A Special Report by Engineering News-Record and Power Magazines

What a difference six months makes. Powerplant contractors are being choosier about what terms they will work under and on many projects are sharing the risks of cost overruns with owners through target prices. A half-year ago such risk-sharing was rare and in most cases unimaginable.

To be sure, the "totally wrapped" project–where all risks are assigned to an engineer-procure-construct company–remains the most common contractual form and isn't likely to disappear. That type of contract is generally replete with performance guarantees and hefty liquidated damages that lenders and bond investors love.

But there are plenty of choices available for contractors today on the hundreds of gas-fired, peak-demand type of plants being built under tight schedules, especially for those classified as "plans- and-specs" jobs. Strategies suited to the seller's market have put some less-than-huge diversified industrial and power contractors, such as Homewood, Ill.-based Graycor and Lake Forest, Calif.-based ARB Inc., in enviable positions. They are loading up on lower-risk work on projects of several hundred megawatts, leaving the megaprojects and the risks of running out of productive craft workers to Bechtel Group, Duke/Fluor Daniel and others.

The changes aren't unexpected. In the past year, contractors had been sending loud and blatant signals that they wanted risk allocation in engineer-procure-construct contracts adjusted now that demand for their services is running higher. Rod J. Ragan, who until recently was a senior energy services executive with Pasadena, Calif.-based Parsons Corp., complained about EPC contractors taking risks for equipment, construction and start-up and performance testing. "Is this fair?" he asked. "Even more important, as hundreds of new generation facilities are planned, can the E&C firms continue to bear this risk?"

Some well-publicized losses helped dramatize the point. In the previous 12 months, Duke/Fluor Daniel and Washington Group International have reported substantial cost overruns and possible penalties on power projects. A year earlier, Stone & Webster had declared bankruptcy and sold itself to The Shaw Group Inc., Baton Rouge. And the 500-lb gorilla of power contracting, Bechtel, is looking at liquidated damages of $31 million on the Red Hills power project in Choctaw County, Miss. Bechtel said in court papers that a lack of skilled workers kept it from finishing on time.

Contractors can now limit their vulnerability to such losses. Only a few years ago, "If an owner didn't like what an engineer or contractor was doing they would just throw the contractor off," says Keith Reisters, a vice president of FMI, the Raleigh-based management consultant and investment banker. "But there's so much work that's not a reality any more. So owners have had to step up" and assume more risk.

 In EPC contracting, "The pendulum has swung past center to the favor of the EPC," says Don Zabilansky, senior vice president of Lockwood Greene, Spartanburg, S.C.

 And the swinging pendulum is redefining strategies about who will work for whom, providing some companies a beachhead on less-risky terrain that was previously off limits.

By limiting the number of projects for which it will compete, Shaw Group, which began performing turnkey contracts in the last few years, says it will work only on a cost-plus basis where its risk is limited to its fee. This is the most conservative approach among EPC companies and the Baton Rouge-based company's ability to succeed with it over several years has yet to be proven.

For many contractors, the return of cost-plus contracts–once a standard during the construction of nuclear powerplants in the 1980s–is a welcome development.

One power industry executive, who asked not to be named, says that such contracts have only a limited role. While he says his company is thinking about "test-driving" some cost-plus contracts on a selective basis, he also complains that "contractors would like to make the whole market cost-plus. It won't happen."

Another power industry executive says that his company will consider negotiating with contractors if it can get the contingency and risk money out of the project price. That could save 8 to 15% on a typical EPC contract.

STUFFED Graycor self-performs key parts of projects.(Photo courtesy of Fritz/Brian/Fritz Photography)

While pure cost-plus remains a rarity, other types of risk-sharing are now common. About a year ago, power developers, especially those with large multiple orders, began taking back the warranty risks associated with the power island equipment. The cost of insurance for liquidated damages associated with these risks had gone sky-high and owners decided they could save money by not paying contractors fees that included insuring those risks.

Risk-sharing on labor overruns and quantities is a more recent phenomena. When one contract involving a target price and shared cost-overruns first crossed the desk of Winter Park, Fla., attorney V. Frederic Lyon nine months ago, "I said, ‘What a fat deal for the contractor.' I have since seen it come up time and time again."

To Raymond F. Rugg, senior vice president for business ventures, sales and planning at Utility Engineering Corp., Minneapolis, the new contracting terms mark the completion of a familiar cycle. "It's a model that used to be done in the 1960s, and it's nothing new. The contractual approach has gone through cycles of the old total reimbursable, to subcontracting lump sum by discipline managed by the client, to EPC. Now it's returning to where the owner can lessen the cost by taking out the risks for the contractors."

Risk-sharing is more common when the owner provides the financing, so leveraged independent power producers and their lenders and investors are unlikely to play the game. Toby Hsieh, a power industry debt analyst with Standard & Poor's (like ENR and Power, a unit of the McGraw-Hill Cos.), says that of all the great many projects financed through bonds "none are done that way. Lenders haven't accepted" the risks of labor overruns, he says.

The new realities appear to favor industrial contractors who define themselves as constructors and shun risks not associated with construction at the site. These companies have strong home bases, knowledge of local labor markets and the ability to self-perform parts of the job or to add value by building more than the base generating units.

Target prices, often used with negotiated construction contracts for which a substantial amount of design has been done, give these companies a greater feeling of security. Under one type, contractors and owners create a target price, but if less is spent, both contractor and owner reap savings. Liquidated damages may be applied to some aspects of the project even if a target price is being used. Often, the contractor's pricing is shown to the owner, and in some cases the built-in contingency fees are given to the owner.

Graycor has one finished and one ongoing project that involve target prices. Graycor is building a 530-Mw, simple-cycle peaking powerplant in University Park, Ill., for PPL Global, a unit of PPL Corp., Allentown. The construction team for the project includes subcontractor McCarl's Inc., a mechanical contractor owned by PPL, and Sargent Electric Co., Pittsburgh. A recently completed project involving a target price is the 250-Mw peaker at Kennerdell, Pa., for Constellation Power Source. The plans and specs for this project were well-developed when construction began.

Bruce Evenson, Graycor's manager of estimating, calls this style of target pricing a dead-band system because only the owner, not the contractor, reaps any gain or suffers any loss if the job falls within an established percentage "band" of the target price. Owner and contractor may split any savings or cost overruns beyond the dead band according to a predetermined percentage. Often, Graycor's share of any penalties is limited to the size of its fee.

The difference between a typical EPC contract and the targeted prices is that the contractor doesn't have to put so much risk money into its estimates. "There has been a shift in business in the market in the last six to eight months where owners are starting to recognize if you want an EPC contractor to take on a lot of risk they will build a lot of money and cost into the estimate to make sure they are covered," says Evenson. "Too many major contractors have gone under because they accepted risks they were not capable of accepting. So our philosophy is that we are a constructor. We don't accept performance risk on any jobs." Graycor, however, will form joint ventures for engineer-construct and EPC construction projects.

Another powerplant contractor, ARB Inc., worked under a target price contract on the new Elk Hills project near Taft, Calif.

After finishing one plant being developed by a joint venture of Sempra Energy Resources and Occidental Energy Ventures, ARB signed up with the same clients for the construction work on another project, the 570-Mw combined-cycle plant in Elk Hills. The contractor says it is working on a fast-track schedule where its payment depends on production and safety incentives. After establishing a target price with a well-defined scope, ARB and its client will share any underruns or overruns. "If we have a bill or quantity and base contract on something that has increased or decreased, we will adjust on unit rates," says Tim Healy, who is in charge of industrial construction for ARB.

He says the company's arrangement on Elk Hills is the result of a good record and relationship.

Lockwood Green's Zabilansky says negotiating possible labor overruns is now a routine practice for his company. "In areas where labor is lower cost and more predictable, contractors are still taking more risk," he says. "But where labor cost is high, and where it's hard to determine how much will be available on the day you break ground, small errors can be costly. We say, ‘Do you want to take the risk? If we do better [and save money], you get the benefit.'"

Urban areas with higher hourly pay rates can be expensive if there are labor overruns. And California can be a hard place to build. One powerplant development executive says that California is difficult because its aging construction craft force can't provide enough people with specialized skills, such as fiber- optic cable connections and chromium pipe welding. "Unions have the labor market locked up pretty tight," says the executive. "California is a whole separate issue."

ARB found itself well-positioned when the power construction market suddenly surged in California. It had done enough power-related work during the slow years, keeping relationships with the constantly-changing cast of power companies, and had been an active industrial contractor with the solid corps of craft supervisors and craft workers now so urgently needed. For now, Healy says ARB won't travel out of California to work on new power generation projects.

Graycor also feels it is well-armed with craft workers. It self-performs much of the civil part of its powerplant contracts.

On the EPC side, the partnership pairings involving engineers and contractors are constantly changing. The only difference, says FMI's Reister, is that now the engineers are assuming more risk in hope of earning a bigger part of the profits.

Utility Engineering Corp. works in joint ventures with contractors like H.B. Zachry and TIC. It generally takes a lump-sum price for its engineering services and shares the overall risk or profit with its contractor partner.

So far, says Rugg, his company has stayed away from exclusive relationships in order to be able to work with contractors in different regions. "Some have better relations with trade crafts" in specific areas, says Rugg.

As a result, he says, designers and contractors don't form exclusive alliances: "Everybody's dating but nobody's getting married."