Understanding O&M contracts
ADAM MUNN* highlights the key issues that must be covered in O&M contracts in the energy sector, to avoid disputes, loss of efficiency, revenue and reputation.
01 March 2009
ENERGY projects invariably consist of a large suite of documents that govern various aspects of the project.
Among these documents are O&M contracts, which cover the operation and maintenance of a project. However, unlike engineering, procurement, construction (EPC) contracts such as FIDIC and MF/1, which are used for the construction and engineering works, there is no standard form of O&M contract. This has led to a degree of irregularity among such contracts. The failure to include a number of basic provisions, and cover key issues, can lead to disputes, as well as a loss of efficiency, revenue and reputation. Such key issues include:
Interfacing
Documents — and parties — must “interface” with each other appropriately. This is especially true of O&M contracts, particularly in the management of the O&M contractor’s relationships with the project company, or special purpose vehicle (SPV) (as part of the supplier/operator pairing with the EPC contractor), and the EPC contractor alone.
The management of delay, damages, caps on liability, warranties indemnities and insurance are often spread across the EPC and O&M contracts, particularly in terms of regulating liabilities vis-à-vis the owner — the SPV. This also impacts upon how insurance is procured and claimed. Maximising practical interface between the EPC and O&M can be vital, especially at start-up and commissioning. Early involvement of the O&M contractor will increase familiarity, understanding and know-how on the project. It will also streamline the EPC contractor’s processes, and allow the O&M contractor to identify and deal with potential long-term O&M issues at an early stage.
Pass-down
As the operation of the plant generates revenue for the project, O&M contracts need to match the terms of the power purchase agreement far more closely than the EPC contract. Certain provisions, for instance relating to availability warranties and O&M standards, must be passed down exactly because it is the O&M contract that covers these issues. Other provisions covering standard contractual issues, such as dispute resolution, must also be consistent with other documents.
Also to be considered are commencement and completion dates, amounts and triggers of liquidated damages, caps on liability, indemnities, entitlements to extensions of time, insurance, land issues (such as state of site at handover to operator and handback to employer, and where obligations of cleaning, remediation, etc are borne), force majeure and intellectual property. The current economic climate may mean the owner and/or its lenders have more power to insist upon certain provisions being passed down.
Clarity of contract
The parties need to be clear as to what exactly is being provided, at what price and for how long. Commencement and completion dates must, therefore, be clearly defined, as must the price, price basis and payment mechanism (for example, fixed cost or cost-plus-fixed-fee). Operators may prefer longer-term contracts (five years at the very least), while owners may prefer shorter-term contracts to maximise flexibility with market options.
Tying the duration to the maintenance cycle and adding six to 12 months is quite common, however. Automatic renewal provisions can also be considered, but the mechanisms to renegotiate the price and duration of the new term must be drafted carefully. The new exit mechanism for the new term should also be considered.
Specification
The requirements and specification in relation to performance, operation and maintenance — including the integrity and consistency of the measurement and testing process — must also be equally clear. Again, accuracy and detail are vital in eliminating ambiguity that could lead to dispute in these areas, particularly when contractor bonuses and damages are tied into reaching performance targets.
Risks & incentives
Contractor bonuses for attaining key performance indicators (KPIs) and performance targets in availability and reliability can benefit the employer by assuring a minimum level of performance, with better output and increased revenue. If performance fails to reach required levels, the employer can levy liquidated damages, as long as they have been calculated as a genuine pre-estimate of loss. The contractor will try to cap damages, for instance, at the level of his expected annual revenue from the project.
Training & IPR
The EPC and/or O&M contractor may be required to train SPV staff to assist or carry out the various testing, commissioning, operation and maintenance. At the same time, the contractors will want to protect their intellectual property. Drafting provisions granting copyright licences and dealing with confidentiality can assist with this. Both parties may also need to look into employment regulations if they plan to transfer staff from contractor to employer during the term, and then back after hand-back of the site and plant after the term.
Exit mechanism
The employer usually needs to be able to terminate for material breach and prolonged continual failure in performance. However, the employer may wish to change the O&M contractor before or at the end of the term for other reasons, such as prevailing or changed economic conditions, or a relationship that was not as profitable as had been hoped for. A right for the employer to terminate for convenience can give a suitable exit mechanism and O&M contractors often agree to this, provided there is an adequate mechanism in the contract requiring them to be compensated (using a mechanism described in the contract).
Summary
As with any other contract, clarity as well as the flexibility to change and manage O&M contracts, is essential. It can be more difficult with energy projects, simply due to the number of parties and project components involved, and the number of documents this entails. Accurate passdown from relevant documents higher up the chain must be combined with provisions covering the key issues, some of which have been highlighted above.
*Adam Munn is an associate in Norton Rose (Middle East) LLP's Bahrain office. The firm has been in the region for 30 years and provides advice on a comprehensive range of issues. It has a dedicated team of experts in the Middle East construction, engineering and energy sectors.
