(a)        Aims

The general aim of the concessionaire when entering into sub-contract arrangements with third parties is to cleanly pass all of the rights and obligations to its principal sub-contractors, clearly this is only possible when the rights and obligations fall within the respective area of competence of the sub-contractor.

 

When this is implemented effectively, the residual risks that are left with the concessionaire should be limited, clear and well-understood by all parties.

 

However, there are two principal risks to be aware of:

 

(i)         Construction delay

Revenue payments will not be available to the concessionaire until the facility is built in accordance with the contract specification. Therefore, if the handover from the sub-contractor to the concessionaire is delayed, the revenue stream due throughout the project period will be shortened. This in turn will threaten the ability of the concessionaire to meet its debt repayment obligations and/or the level of return the concessionaire’s shareholders will make on the capital invested. If the EPC contractor never completes the facility then this may lead to termination of the concession agreement and the consequences for the lenders may be even more severe.

(ii)       Poor performance of operation and maintenance

The performance of the services to be provided during the operational phase of the project will be measured against certain performance indicators. Failure by the O&M contractor to meet these standards may permit the government to reduce the availability fee through pre-determined deductions, or lead to a loss of user revenues if potential users select alternative options as a result of quality concerns.

If the level of deductions / revenue loss is too high, this will also threaten the ability of the concessionaire to meet its debt repayment obligations and/or impact on the level of return the concessionaire’s shareholders will make on the capital invested.

The sensitivities of the lender in this regard are reflected in their requirement for pass-down or back-to-back sub-contracts. As the names suggest, these sub-contracts work by “passing down” or “passing through” all of the obligations and entitlements of the concessionaire under the concession agreement to the relevant sub-contractors so that the provisions of the agreements either side of the concessionaire are “back-to-back” with each other.

 

There are two main ways to prepare such contracts:

 

(i)         Amended standard forms

A drop-down contract could be drafted by starting with a standard form contract (e.g. FIDIC Yellow for EPC works) and amending it so that it includes all necessary obligations and other provisions from the concession agreement.

(ii)        Bespoke forms

Alternatively, the drop-down contract could be drafted by starting with the form of concession agreement and then removing the sections which do not relate to the works or services (as appropriate), changing the names of the parties and the remainder of the drafting as appropriate.

The bespoke form of contract is most commonly seen in practice because it ensures that the relevant clauses of the concession agreement and sub-contract match each other word-for-word to the closest extent possible.

However, this drafting approach cannot by itself guarantee that the concessionaire will have a neutral position between the government and the sub-contractor, this is due to the effect of the doctrine of privity of contract.

For example:

 

The government restricts the building contractor’s access to the site for a month. Both the concession agreement and the EPC contract allow for a “reasonable extension of time” to be awarded in the event of denial of access. The EPC contractor goes before Adjudicator X under the EPC contract dispute resolution procedure, who awards 45 days extension of time (EOT) and compensation. The concessionaire then goes before Adjudicator Y under the concession agreement dispute resolution procedure.

 

Adjudicator Y is not bound by the decision of Adjudicator X, whose decision was given on a different contract, and awards only 30 days EOT and compensation. If the project is then delivered 60 days late, the concessionaire will suffer financial loss for the delay between the 30th day and the 45th day of delay. This loss will be a considerable sum as a delay in handover of the facility will translate into an irrevocable loss of the revenue payment for that period, and the concessionaire’s obligations to start repaying the debt will usually commence from a fixed date. Such a result would clearly be unsatisfactory for the lender.

 

(b)        Equivalent project relief

To deal with the above issues, it is common for PPP sub-contracts to contain what are commonly referred to as “equivalent project relief” or “EPR” clauses. The substance of an EPR clause in plain English language is as follows:

 

You, the sub-contractor, shall only become entitled to relief (by way of payment, extension of time or otherwise) under this sub-contract to the extent that we, the concessionaire, have become entitled to such relief under the equivalent provisions of the concession agreement.

 

In return for accepting such a limitation on its right to relief, the sub-contractor will typically be given the right to force the concessionaire to put forward equivalent claims against the government and to have control as to how these claims are run. However, the sub-contractor, being the beneficiary of any proceeds, will often be liable for the costs of the process.

 

In theory, a clause of this nature will remove the concern that the concessionaire will face inconsistent decisions at project agreement and/or sub-contract level, either in terms of the outcome of the decisions or their timing.

 

(c)        Key commercial issues

Even where the contract drafting is aligned and equivalent project relief clauses are introduced, this does not mean that the concessionaire will be able to completely isolate itself from project risk. There are some key areas of negotiation between concessionaires and sub-contractors which are explored in this section; these commonly define the extent of retained risk left with the concessionaire (and which the lenders therefore need to take into account as part of their lending decision).

 

(i)         Caps on liability and carve-outs

Concession agreements tend not to have express limitations of liability because one could take a view that the concessionaire’s exposure is limited to its invested equity and debt. If liabilities exceed this value it can choose to become insolvent rather than secure more money from third parties; the concessionaire itself has no other business it needs to protect.

 

Contractors, however, are fully trading entities with multiple contracts. An uncapped exposure on one contract could bring down other contracts that it currently has in place or even the whole company. From a corporate risk perspective, therefore, contractors will not enter into contracts with uncapped liability, in dropping down the concession agreement terms, a new limitation of liability clause needs to be added.

 

Wherever the cap is set, it means that the concessionaire now takes the risk that the contractor’s exposure will exceed the cap and thus the liability will revert to the concessionaire. Typical EPC contract caps are between 30-50% of the contract price; sometimes caps are even higher in infrastructure projects. A cap of this size would appear to leave the concessionaire and lenders significantly exposed, but the lenders will rely on technical advice to confirm that the capped amount will be sufficient to cover all reasonable downside scenarios. If the project is linear or consists of multiple separate units, the risk of the entire project failing must be relatively low.

 

Typical O&M contract caps are a function of the operating fee: it often comprises 100% of the operating fee as an annual cap and 200% of the operating fee as a termination cap. Again, technical advice will satisfy the lenders that the concessionaire’s residual risks can be managed in all reasonable downside scenarios.

 

Nevertheless, some liabilities will be carved out from the caps. This would typically include liability arising out of fraud or deliberate breach, insured liability and certain indemnity liabilities like personal injury or IP claims. Other carve outs may be negotiated on a case by case basis, but this will usually be a contentious issue.

 

(ii)       Performance security

Even if the government does not request performance security from the concessionaire (and it may not need to because the concessionaire has already invested debt and equity into the project), the concessionaire has to manage the solvency risk of the sub-contractors. Performance security may include:

 

(i) parent company guarantees from the sub-contractor’s group companies;

 

(ii) performance bonds to cover the cost of finding a replacement contractor on termination, or just to cover a failure to pay damages when they fall due (10% of the contract price would be typical, typically returned on certification of completion or the end of the defect liability period);

 

(iii) a retention from payments (or a bond in lieu of retention) (3-5% of contract price would be typical, typically halved on certification of completion and returned at the end of defect liability period);

 

(iv) an advance payment bond, should any advance payments be made.

 

(iii)      Delay and insurance

If the construction works are delayed the concessionaire will expect to suffer a revenue loss, and the sub-contract should therefore ensure that the EPC contractor is liable to pay suitable liquidated damages to the concessionaire over the period of delay.

 

The EPC contractor will often expect its liability for liquidated damages to be capped, either by amount or by time, 10% of the capital cost by value is commonly seen. From the concessionaire’s perspective, the liquidated damages cap should at least be sufficient to cover lost revenue until the longstop termination date in the concession agreement.

 

Some delays may be caused by insured events. In this case, who takes the deductible, the concessionaire or the EPC contractor? Who takes the cashflow risk of meeting the project debt while an insurance claim is made? These are all negotiable points.

 

What happens in the case of force majeure? Normally the contract will provide that force majeure relieves a party from liability, but it does not provide the party with compensation. If this risk is passed down to the EPC contract, the concessionaire will find itself left with a shortfall as there will be no revenue due under the concession agreement but also no damages due from the EPC contractor.

 

(iv)      Termination events and other buffers

When passing down the termination events (events of default) from the concession agreement to a sub-contract, the concessionaire and lenders will want to ensure that adequate buffers are included so that the concessionaire has the ability to terminate the under-performing sub-contractor in good time before the termination event arises under the concession agreement.

 

In addition, the sub-contract may need to contain a number of additional termination events that are not present in the concession agreement, such as failure to procure performance security when due, or reaching a cap on under the sub-contract (on the basis that it would not be reasonable to continue a contract under which the contractor can incur no further liability, so the contractor must accept that if it does not increase its cap it may be terminated).

 

(v)        Interface issues

A perennial risk for a concessionaire is that when a physical problem occurs with the works it may find itself stuck between competing defensive arguments from its sub-contractors. If a problem arises in the facility, the EPC contractor may say that it arose through a failure of maintenance, and the maintainer may say that it arose due to poor design or workmanship. In the meantime, the concessionaire may be suffering from the consequences of the event under the concession agreement, for example by way of financial deductions for non-compliance.

 

An interface agreement is one way to address this. In this arrangement, the EPC contractor and O&M contractor both sign an agreement (together with the concessionaire) in which they agree that they are collectively responsible for the condition of the facility. In the event of a dispute like the one mentioned above, the concessionaire would have the right to allocate the responsibility for the non-compliance to either the EPC contractor or the O&M contractor on a good faith basis.

 

Typically these agreements would apply throughout the EPC contractor warranty period. After expiry of the warranty period, the risk of latent defects left by the EPC contractor may remain with the O&M contractor, or it may revert to the concessionaire. However, this is usually a negotiable point.

 

(vi)      Lifecycle maintenance

The O&M contractor may be given responsibility to manage the condition of the facility for the operating term. Over time, the maintenance expenditure is unlikely to be constant but rather spiky in profile with peaks occurring when major equipment needs to be replaced (life cycled) and with greater expenditure occurring toward the back end of the operating period.

 

The question then comes as to how the O&M contractor should be paid. Despite the fact that the concessionaire’s income is typically flat over the concession period (subject to demand growth and inflation), the lenders may be nervous to pay the O&M contractor on a similar basis in case the O&M contract is terminated early. If this does occur, the O&M contractor may have effectively been paid in advance for lifecycle works that it has not carried out. For that reason, it is common for lifecycle expenditure paid to the O&M contractor to be subject to tighter controls.

 

In some projects the concessionaire maintains the life cycle fund and spends money as and when it is required, this is usually based on the O&M contractor’s recommendations as to when assets have reached the end of their serviceable life. If there is an excess of funds against the modeled or predicted expenditure, this benefit stays with the concessionaire.

 

In other projects the O&M contractor takes the risk in terms of the sufficiency of the life cycle fund, this is because it may have prepared the relevant life cycle maintenance estimates for the project’s financial model in the bidding process. The concessionaire will agree to release monies to the O&M contractor for replacement work when required, but never in excess of the modeled amounts. If the O&M contractor needs to spend more than this to meet its obligations to have a functioning asset then it has to meet these expenses from its own resources.

 

SUMMARY OF KEY POINTS

Sub-contract risk pass-down When a concessionaire enters into sub-contract arrangements with third parties, it aims to cleanly pass all of the rights and obligations owed to the principal contractors where applicable. Any residual risks outside of the sub-contractor’s competence remain with the concessionaire. However, two key risks are (1) construction delay, the concessionaire will not receive revenue payments until the facility is built in accordance with the contract specification, any delays shorten the project period during which a revenue stream would have been expected which consequently threatens the concessionaire’s ability to meet its debt repayments and (2) poor performance of operation and maintenance of the project, which can lead to penalties and deductions to the availability fee. To avoid these risks materializing, lenders require ‘back-to-back’ sub-contracts to be drafted, this can be done by way of a market-accepted standard form contract being amended to include all necessary obligations from the main concession agreement, or a bespoke contract being created using the concession agreement as the base of the contract. It is common to see “equivalent project relief” or “EPR” clauses in sub-contracts which only entitle the sub-contractor to relief if the concessionaire has become entitled to the same relief under the concession agreement. However, the sub-contractor often demands the right to force the concessionaire to put forward equivalent claims against the government and to have control as to how these claims are run, which it can then benefit from. Certain key commercial issues will be negotiated between concessionaires and sub-contractors to establish the extent of the risk that remains with the concessionaire, this includes delays and insurance, events of default which need to be triggered in the sub-contract before such events are triggered in the concession agreement, caps on liability for the sub-contractors and performance securities in the form of guarantees so that the concessionaire can manage the solvency risk of the sub-contractors.