This bulletin was prepared by senior associate Antoinette van der Merwe and candidate attorney Roxanne Gilbert.
Engineering, procurement and construction (“EPC”) contracts are commonly used to undertake construction works in complex, large scale infrastructure projects. Currently in South Africa we are seeing a shift from larger renewable energy solar projects developed by independent power producers to small-scale, off-grid renewable solar power projects (“Captive Solar Projects”).
With the emerging popularity of financing these Captive Solar Projects on a portfolio finance basis, and the inherent risk mitigation of funding a number of projects, it is no longer necessary to conclude lengthy, complex and burdensome EPC contracts, as typically used in larger project financed power projects.
In Captive Solar Projects, short form construction contracts, containing only the essential commercial and legal terms, are sufficient and still capable of providing lenders with the necessary safeguards they require.
Below are five reasons to opt for a cost-effective and expedient, short form construction contract for Captive Solar Projects:
Nature of the Construction
Although a Captive Solar Project entails certain elements of design and construction, it primarily comprises of the installation of preassembled or free-issued photo-voltaic (“PV”) panels. The PV panels are then tested and commissioned together with the interconnection equipment required to connect them to the customer’s premises.
These electricity generators are connected or “grid tied” to the Eskom grid, and operate in parallel to the Eskom grid in order to supplement the energy that would otherwise have been imported from Eskom. While the PV panels and associated equipment are designed to suit the customer’s unique specifications, the construction, installation and testing requirements are uncomplicated.
It is worth noting that in contrast to a traditional EPC contract, the customer usually remains in possession and in control of the project site in a Captive Solar Project and the contractor never assumes full responsibility or liability for the site or the ground conditions. In addition, the site will usually be an established one, without the usual and often extensive risks associated with a greenfield project. The risk allocation of a typical EPC contract is therefore overly burdensome for a contractor who is only responsible for the installation of a PV system.
Duration of the construction
Depending on the size of the generation facility required by the customer, the installation, interconnection and testing of the equipment associated with a Captive Solar Project, takes on average, between two to six months. This means that there is no protracted presence of contractors on project sites which eliminates a great deal of the associated health and safety risks that would otherwise be present.
Value of the Captive Solar Project
Captive Solar Projects are designed to produce enough energy for the customer’s sole consumption and therefore the value of an individual project, by comparison, tends to be significantly lower than major infrastructure or power projects and is ultimately one of the main reasons why such projects tend to be grouped together (on a portfolio basis) for purposes of financing. Furthermore, the risk of damage or loss, and the risk of technical difficulty occurring on a single Captive Solar Project, is similarly reduced, especially when such project is viewed as one of multiple projects.
One of the key components of an EPC contract is the procurement function of the EPC Contactor. On a major infrastructure or power project, the EPC Contractor would apportion the works to various subcontractors after the required tender procedures have been undertaken (such as major equipment suppliers, civils, mechanical and electrical contractors). However, in the case of Captive Solar Projects, the developer tends to either carry out the works itself or through a single contractor or project development partner. Due to the nature of Captive Solar Projects, complicated procurement processes, generally, do not play a significant role and robust procurement capabilities are not a consideration.
Nature of financing
Large infrastructure projects are often financed on a limited or non-recourse basis, where the sponsors establish a special purpose vehicle to ring-fence the risks associated therewith and the recourse of the lenders is limited to the project assets. The lenders largely rely on the revenue streams generated from the offtake agreements and concession agreements to repay the debt.
Captive Solar Projects are not capital-intensive projects and accordingly do not always require external debt funding or are not typically of a size that would make it worthwhile for a lender to fund. However, if the sponsor acquires a “portfolio of projects” this will allow lenders to group multiple individual projects together under one financing structure. The risks a lender experiences with a single asset are mitigated by grouping the assets together, as an individual defaulting project can be removed from the portfolio without having to bring down the entire structure.
Although South African lenders usually prefer a fully-wrapped EPC contract arrangement for infrastructure projects, it is not always feasible for smaller developments that require external debt funding. Despite the fact that Captive Solar Projects still contain certain design and construction risks, these risks are sufficiently diluted when they form part of portfolio financing, they are also adequately diversified to accommodate a more cost-effective, short form construction contract.
To the extent that the short form contract sufficiently addresses key commercial and legal risks, it will provide lenders with the necessary safeguards and thereby negate the need for a fully-wrapped EPC contract, which cannot be justified in these instances.