Construction Arbitrations Involving Energy Facilities
Between the years 1973 and 2017, the world’s consumption of energy has more than doubled. This shows the mounting need for energy sources. As a result, there has been a higher demand for the construction of energy facilities. In close relation with this, construction arbitration has come to be the go-to when it comes to settling disputes that arise from contracts for the construction of these facilities.
In this article, we’re going to be considering key issues of risk that come up in contract drafting and how they can be addressed, as well as issues of legal and contractual principle that usually come up in construction arbitration disputes.
We’ll be looking at them under five headings;
- Time: Time is a very important aspect in the construction of energy facilities, and the consequences of a delay in projects like this can be numerous. They can include an increase in costs for the contractor; loss in production and revenue for the owner; negative effects on the payback of loans to financial partners; cash flow and subsequent solvency issues of the project; a resulting delay in multi-phase projects and negative publicity especially for government-funded projects
Time-related risks are most times allocated to the contractor, because at the beginning of a project, when a contract is drafted and presented, the start time is indicated, as well as a proposed date for the completion is also stated. Also, allowances are made for any extra or unplanned delays. So, in the case of any delays, the contractor is usually held responsible for not adhering to the agreement of the contract, except for cases/instances where these delays were caused by the project owner. But when these owner-caused delays occur, the contractor may seek a range of remedies against the owner, including extensions of time and damages.
Also, an event such as a force majeure may affect the contract, and this has been a source of heated contention. But with the emergence of the covid-19 pandemic, contracting parties are more aware of this reality and may therefore seek to carefully address the risk allocation of this type of event within their contracts.
Several types of disputes have arisen with regards to delay in construction arbitration. One of which is
Owner claim for liquidated delay damages
There is a liquidated damages clause in construction contracts that is available to compensate the owner if the contractor fails to deliver within the stipulated timeframe. This clause levies from the contractor some monetary sum that is relative to an agreed percentage of the total contract price (usually 10-20 per cent). This sum totals the pre-estimate of all the losses that an owner can suffer as a result of a delay in completion, and is compensatory rather than punitive.
The main rationale behind liquidated damages clauses is to avoid the complex and costly task of proving losses arising from the delay individually as is required in the general principles of contract recovery.
However liquidated delay damages claims are limited by two key principles: the penalties doctrines and the prevention principle.
The penalties doctrine
This states that when a liquidated damages clause, states a sum that is not synonymous to the value of the construction contract, such that it takes the form of payment in terrorem, the court will not enforce the clause. The fundamental stand of the law is that a liquidated damages clause must be compensatory and not punitive.
The prevention principle
This states that the owner will not be able to claim a liquidated damages clause against the contractor for delays that were caused by the owner. The rationale behind this is that the owner can no longer rely on the original date slated for completion and so there can be no fixed date from which the liquidated damages could run.
- Cost: The need to present a complete work within budget is known as the cost risk. Projects for the construction of energy facilities generally work with a lump-sum fixed-price contract structure, which naturally places cost risk on the shoulders of the contractor. This fee will be based on deliberate negotiation and assessment of costs. But, regardless, cost overruns will eat directly into the contractor’s profits.
There are two exceptions to this default position.
The first consists of cost overruns that the law dictates will not be borne by the contractor. These may include costs overruns flowing from an owner’s prevention acts or breach of contract.
The second category comprises cost overruns arising from neutral events for which the contractor is not responsible according to the terms of the contract. The parties involved have the free will to allocate risk for neutral delays in any manner they deem fit during the negotiation of the terms of the contract.
A great risk in construction is that which relates to defects in a contractor’s performance or the ultimate facility under construction.
The risks associated with quality fall into two categories:
(1) The risk that the performance does not comply with clear contractual dictates for materials and workmanship
(2) The risk that the facility is not fit for the intended purpose (that is, it is not suitable to meet targets and earn revenue upon completion).
The project engineer is always the neutral arbiter called upon when it comes to resolving disputes about quality at the construction site and is armed with the power to issue certificates as to the quality, cost, and time. The status of that certificate will be first be determined by contract, and also by following applicable rules of law.
The scope of work that the contractor is required to carry out is generally stated before the bid phase of a project. At this stage, there is a selection of methodology and the specification of core functions and performance criteria for the end-user facility. In projects for the construction of energy facilities, this will generally require designation of a design and construct or turnkey methodology, identification of the key features and the layout, and specification of the needed output capacity (e.g. mega wattage that is generated by a power plant, or the total barrels produced by oil pipelines and platforms). These criteria will then be presented formally, in as much detail as the owner desires, in the final contract documentation…
A risk trade-off occurs at this point:
Additional detail in the employer’s requirements will result in less openness for the contractor in terms of performance and therefore a greater risk of change orders.
The less detail in the employer’s requirements, the less likelihood of change orders but then, the greater risk that the contractor will produce an ultimate work that does not quite fit the owner’s desired facility.
The risk allocation has been said to be with the contractor, who is expected to deliver a completed project, promptly, and for the agreed sum.
But this might be true in a hypothetical situation where the project owner perfectly defines the scope of work in technical documents, and this is most often not the case.
These issues are addressed through risk-allocation provisions and contractual clauses that give ‘variations’ and ‘change orders’ where necessary.
- Political, economic and social: Project owners and contractors alike are both prone to financial repercussions of political, economic and social factors on an energy project. These factors are closely intertwined. Political decisions are made based on economic and social considerations which lead to legal changes. Three manifestations of these risks that arise from time to time in energy projects are:
Risk 1 – changes in applicable laws, which includes changes in tax arrangements or subsidies, local content requirements, local labour laws, tariffs and other terms of trade.
Risk 2 –the contractor price risk stemming from changes in the market for supplies needed for construction.
Risk 3 – the owner price risk stemming from changes in the market price of the energy commodity to be produced.
Recovery for losses stemming from these risks will only be possible if a contractual right of recovery or contract price adjustment has been negotiated and agreed upon between the parties. This demands for a commercial decision by the parties: as to whether risk from political, economic and social factors should be left to lie where it falls or be allocated between them.
It is evident, that issues that arise in construction arbitrations as regards energy facilities consist of the same fundamental claims, legal principles as the broader world of construction disputes, and contractual issues. The energy industry, however, comes with its additional complexity in the form of political and economic forces at an international level, and strict production-driven scheduling and performance. This article has sought to provide a brief introduction to many of these issues and the commercial risks that come with them.