This article is a follow up to our two part essential guide on feasibility planning and construction procurement for junior mining and our analysis last year of the updated FIDIC suite of contracts and their suitability for mining projects.
The article summarises the recent procurement trends in the mining sector and focuses in particular on the changes we have seen to traditional EPC contracting structures in a Chinese debt context, the increased sophistication of EPCM incentive mechanics and the resurgence across the sector of owner-managed project delivery structures.
Changes to Chinese EPC contractor financing structures
The resource sector was hit hard by the credit crunch. The crash in commodity prices and the absence of debt for project developments, while adding further stress on the sector, has over the last 10 years led to an increase in the amount of Chinese bank and ECA financings as the market adapted.
Chinese EPC Contractors or Chinese equipment suppliers were often a Sponsor’s first introduction to Chinese sources of finance. The major advantage of a Chinese EPC Contractor is that not only will they be able to offer to provide a complete engineering procurement and construction package providing machinery and equipment (usually on economic terms) but also access to funds from Chinese banks to ensure that the project can be implemented.
This development has been a welcome relief to projects which found their project finance backers disappearing during and following the credit crunch and the commodity price crash.
While every deal has its own peculiarities, rather than having a traditional project finance structure, Chinese bank funding was typically made available to projects that were procured on a turnkey basis, which included some form of Chinese component, and which were structured such that the funding was made direct to the supplier / EPC Contractor (following a drawdown request by the Project Company), unless it was used to refund the Project Company for payments already paid to the supplier / EPC Contractor.
The relatively recent introduction of the Chinese government’s State Administration of Foreign Exchange (SAFE) regulations and approvals has imposed requirements that can restrict the transmission of foreign currency funds out of China by Chinese EPC Contractors and banks. This has made the traditional Chinese structures described above more challenging for Sponsors.
Again we have seen the market adapt with the development of novel financing structures to help facilitate continued Chinese bank and ECA involvement. In particular we have seen the introduction of a promissory note whereby the Project Company issues deferred payment obligation promissory notes to the Chinese EPC Contractor in respect of each invoice issued by the EPC Contractor under the EPC Contract. Where the EPC Contractor is issuing invoices against agreed milestones, then a new promissory note would be issued when each milestone is achieved. The EPC Contractor then transfers the promissory notes to the Chinese bank in exchange for payment (in China) for the work certified under the invoicing procedure in the EPC Contract thereby keeping a significant portion of foreign currency onshore in China.
The repayment period for each promissory note will be determined on a project to project basis but where promissory notes are issued to be repayable within a three year period for example, then the debt could potentially become due for repayment during the construction period if there have been significant delays to the construction works.
It should be noted however that in-country considerations will be key when considering if such a structure can be adopted. In particular: (i) there may be limits on the levels of cover that SINOSURE can provide in a given jurisdiction and therefore the total value of EPC services the Project Company can procure, (ii) the structure of the transaction can be complex and will need to be explained to local partners and/or the state shareholder, if any, (iii) exchange control restrictions may limit the funds which can be used by the Project Company to repay the promissory notes, and (iv) the use of promissory notes may not be recognised as a matter of local law – local law advice will be required in each case to confirm this.
There may however be alternative options to a promissory note: for instance, assignment of the EPC Contract or a payment order acknowledgment in lieu of a promissory note. In our experience, there is a much better prospect of raising Chinese finance if there is adoption of a structure with which the relevant Chinese banks and ECAs are familiar.
EPCM incentive mechanics – increased sophistication
Where the Sponsor is a sophisticated and experienced entity able to manage delivery of the works either on its own or in conjunction with other consultants without the need for an EPC wrap of construction delivery risk, the Sponsor may opt for an EPCM contracting structure.
The EPCM solution is the preferred procurement structure for junior miners, since it can offer significant advantages if properly managed. Initial capital estimates for completion of the works can be significantly lower under the EPCM solution when compared with EPC fixed price “turnkey” solutions.
Historically, the mining sector has tended to see quite an unsophisticated approach to EPCM contracting when compared to other sectors where the model is commonly used (for instance, in the petrochemicals industries).
Well-advised Sponsors in the mining sector are however seeing that contractors undertaking EPCM services are increasingly willing to accommodate a more onerous risk profile under which the EPCM contractor may be more effectively incentivised to manage time and cost overrun exposure for Sponsors.
The EPCM contractor will not backstop project delivery risk and, importantly, the achievement of key project targets. The EPCM contractor will however be responsible for managing the same on behalf of the Sponsors.
The challenge for Sponsors will be to incentivise the EPCM contractor to manage project delivery and the achievement of key project targets effectively and proactively. The approach typically adopted relies on an incentive structure which provides positive (and sometimes negative) incentives to the achievement of key project targets.
These provisions are generally bespoke and may be underpinned by fairly complex calculations but equally can be fairly straight forward depending on the approach preferred by Sponsors.
Typically, incentive regimes cover the following:
- bonus payments for the works being completed on time or within a fixed period following the scheduled completion date;
- bonus payments for the works being completed for an overall outturn cost below or within a fixed amount over the outturn cost budget;
- bonus payments based on the health and safety record at the site; and
- bonus payments for completing the required EPCM services within the projected budget for such services (based on projected man hours at the agreed rates),
but there will always be variations on the approaches outlined above and the proposed approach will tend to be shaped by the concerns the Sponsors may have in respect of key aspects of project delivery.
It will be a matter for the Sponsors to consider commercially whether the incentives should remain payable where extraneous circumstances outside of the control of the EPCM contractor have undermined the achievement of the relevant project targets. We have seen varying approaches in this regard.
Since the EPCM contractor will typically set key project targets (eg, the project budget and the project programme), appropriate due diligence will need to be undertaken by the Sponsors to establish that the project targets are sensible in the context of the project proposed.
More recently, we have seen EPCM contractors willing to accept negative incentives around the achievement of the key project targets, such that they are prepared to place an element of their profit at risk. This approach has been commonplace in other sectors using the EPCM model for some time but it is now becoming more common in the mining sector.
Owner-managed projects – E + P + C + M
Rather than paying the premium involved in transferring the entire risk in works delivery to a single contractor on a turnkey basis, or appointing an EPCM contractor for a considerable fee, the Sponsors may instead choose to procure and manage the individual works and supply packages themselves through an owner-managed procurement and project delivery structure.
Under such a structure the Sponsors procure each of the packages separately and will be responsible for managing the various project interfaces themselves. Owner-managed projects are not typically complete self-delivery however and, depending on the sophistication of the Sponsor internal team, will usually involve the appointment of consultants to assist the Sponsors in delivering the required mining infrastructure.
Such consultants are however only employed in relation to discrete aspects of the project and will not provide the same level of recourse for underperformance that an EPCM contracting structure described above would otherwise provide.
The internal capacity of the Sponsors’ team to manage the project actively, anticipate the issues and ensure the project contracts are administrated properly will be a key determinant of whether or not an owner managed solution is appropriate.
Where the Sponsors have an experienced internal team that is able to manage the procurement and delivery of the works and any third party consultants employed, Sponsors might not see value for money in the higher capital delivery costs accompanying an EPC solution that wraps construction delivery risk or even the fee payable to an EPCM contractor.
Lenders to any owner-managed projects will however need to see that any retained risks are properly and appropriately managed by the Sponsors. A financially robust main construction contractor with in country experience and a proven track record in the delivery of similar mining infrastructure is a key mitigation for Lenders. The level and nature of security required by Lenders will be determined on a project-specific basis.
While Sponsors may not see value for money in EPC or EPCM contracting structures Lenders will likely require a significant cost overrun facility to be put in place to deal with the consequences of the Sponsors failing to deal adequately with the retained construction delivery risks associated with an owner-managed structure.
Sponsors will need to undertake a detailed cost benefit analysis bearing the Lender requirements in mind to determine if the owner-managed approach does in fact provide the value for money that it may on the face of it indicate. In our experience when such projects go over-budget because of a failure to manage construction risk appropriately they tend to go significantly over budget, which can have devastating consequences for less established Sponsors.