Risk sharing contracts increasingly used in volatile mining market

Risk allocation in mining contracts are increasingly giving way to more collaborative and shared risk models under certain contractual arrangements in volatile market conditions
Risk sharing contracts increasingly used in volatile mining market
REUTERS/Chris Wattie

Risk allocation in mining contracts are increasingly giving way to more collaborative and shared risk models under certain contractual arrangements in volatile market conditions, construction lawyers say.

The use of engineering, procurement and construction management (EPCM) contracts for large infrastructure projects has challenged both lenders and contractors appetite for risk when considering building a project, by forcing them to share more in the risk than they do with other types of contracts.  

Under a traditional engineering, procurement and construction (EPC) contract, the company owner pays a fixed lump sum priced after front-end engineering and design is completed to a contractor to complete a project, with most risk taken on by the contractor. Under an EPCM contract, the owner pays the contractor to design and manage the project, but not to build it or supply materials the contractor and owner both oversee the equipping and constructing of the project, with the owner contracting directly with the sub-contractors procured by the construction manager.

The EPCM arrangement can be cheaper because the owner takes on more oversight and risk by dealing directly with the sub-contractors, unlike an EPC contract, where such contingencies are factored in as the contractor builds the project.     

Lenders prefer EPC because there is less risk to the owner; to their borrower, says Alison Lacy, a lawyer at Fasken Martineau DuMoulin LLP.

Lacy says she expects to see more EPCM contracts in the sector because, from a contractor's perspective, the risks are too great to bear.

Because of cost issues, uncertainty issues...the contractors are reluctant to take on EPC because theyre taking on all the risk when they do that, and theres been so many stories of cost overruns, schedule delays, that the contractors dont want to take all that on, and theyre pushing back and theyre pushing that onto the owners, Lacy says.

For an EPCM to work with lenders, the lenders have to be comfortable with the interaction between all of the contractors doing the construction work so theres less risk of (deadline) slippage that can directly harm the project, Lacy adds.

With an increase over the last few years of EPCM contracts for large infrastructure projects, some see more collaboration on projects with less emphasis placed on trying to shift the risk. 

I think the amount of time and energy that is spent trying to affect that kind of risk transfer is largely misplaced, and I think that what we are seeing in more creative industrial applications is a more collaborative and shared risk model that I think has a lot to recommend it in the mining sector, says Duncan Glaholt, a construction lawyer at leading construction law firm Glaholt LLP.

Matthew Alter, a construction lawyer at Cassels, Brock & Blackwell LLP, says for an EPCM to be successful, the owners have to be engaged in the process.

The point about EPCM arrangements is that, for them to be successful, the owner has to be involved and engaged in the process; and if its a long duration project, a critical point from an owners perspective, which then translates to the lenders interest, is that the contractor has continuity of its management team on the project, so there is historical knowledge of the project, Alter says. It doesnt help the success of a project if the EPCM contractor is switching site supervisors every few months, or after various phases of a complex project.

When done properly, the EPCM approach allows an owner to commence construction of a complex project in stages and to control costs, through its involvement in the design and in the direct award of trade and supplier contracts. This approach can prove beneficial to owners and contractors, alike, in a more volatile market.

Lacy says there are an array of options for owners and contractors when dealing with risk under EPCM contracts, including even switching contractors mid-project via a method called gating.

Owners, contractors, lenders are being perhaps more creative, and going with hybrid versions of the typical standards of documents; or theyre going with gating, so you have to reach a certain point in the project under a certain agreement and then you move on to a different agreement and perhaps even with a different contractor.

While there has been a noticeable increase in EPCM contracts across a broad range of sectors, including mining, the types of contracts used are dependent on a variety of factors.

In the oil and gas business, for example, theres a cadre of what I would call high-value, repeat transactions, Glaholt says. The oil and gas industry draws on a pool of a half a dozen major EPC contractors, and that market is so tight and the risks are so well-known, that theres a tendency in that business for certain applications to favour EPC.

On the other hand, theres almost an irresistible attraction, if youre on the owner side of the equation, to go EPCM because you believe that you know your business and you can go EPCM and save a lot of money on the risk-transfer side.

Glaholt adds that EPC contracts are popular among the more evolved mining companies as opposed to the juniors that have the luxury of having one source of responsibility for the risk. 

Alter says, in the past two years, he has been involved in both a domestic mining project that is using an EPCM contract, as well as a South American mining project that is using a lump sum EPC contract. However, he says that the majority of the mining projects that his firm is involved in tend to use the EPCM arrangement.

Most recently, on March 17, Red Eagle Mining Corp. hired Lycopodium Minerals Canada Ltd., an international project management and engineering firm, as its EPCM contractor.

The Vancouver-based mining company is using a hybrid EPCM, which includes its own construction management and the involvement of a local Colombian engineering group for the detailed engineering. The contract between the two companies includes fixed labour rates, process guarantees and capital cost and schedule bonus/penalty terms, according to Robert Bell, Red Eagle's COO and director.

Bell says the two companies have enjoyed a relationship for over a year, and warns that when it comes to choosing a contract, the choice depends on the engineering company.

An investment in the right choice EPCM engineering group is good insurance of quality project development, Bell says. However, and most importantly, the choice of engineer lies in the fact it must be a small boutique group who you are very familiar with, and that the [terms and conditions] are not onerous.

We all know in the past (and now, for that matter) that many major engineering groups have grossly overcharged mining companies in project development, and the mining companies (particularly the majors) have blatantly allowed this to happen.