Performance guarantees and liquidated damages

This follows on from yesterday’s post on Delay Liquidated Damages, as there are a few principles that overlap.  Most notably of which is that the Employer’s biggest stick in an EPC contract is the use of financial penalties if the Contractor doesn’t meet what they have agreed to in the contract.

Possibly my favourite cartoon ever.  Via XKCD.

Where DLDs are used to protect the Employer against delays, contracts make use of performance guarantees to ensure that the facility does what it was intended to do.  This post looks at two types of guarantees and penalties that exist.

Guarantee on installed capacity

Prior to achieving practical completion, or meeting the commercial operation date (COD), there will be a list of activities that need to be completed.  These will include (amongst others) commissioning activities, pre-COD performance tests, and the submission of required documentation.  The contract is likely to require the Contractor to demonstrate that the constructed facility meets the stated technical specifications, including the overall installed capacity.

For instance, for a PV facility, this may mean that the nameplate capacities of all the modules installed need to add up to, say, at least 100MW.  If the Contractor finishes the installation, and for one reason or another, the modules do not add up to 100MW, the Employer would naturally be disinclined to pay the full contract price for an inferior product.

It is at this stage that the contract would allow for a reduction in the overall contract price, if the Contractor has under-delivered on the facility’s capacity.  Note, the contract should not include any allowance for the Contractor to receive additional funds if the facility is over capacity.

The calculation for amounts owed may be as simple as a pro-rata adjustment of the contract price based on capacity delivered, but this may differ from project to project, and technology to technology.

Guarantee on facility performance

The performance tests that take place prior to achieving COD are typically carried out over a week or two.  They are there to show that the facility can perform as expected, but they are not long enough to show if there are operational issues that may only show themselves over a longer period.  For instance, the pre-COD tests may take place during the low-wind season.  This means that the tests show how the facility operates when wind turbines don’t have to rotate at high speeds.

Enter the performance monitoring period.  This often overlaps with the Defect Liability Period (during which the Contractor is on the hook for any equipment or construction defects that show their face), but is not necessarily directly linked to this (more on the DLP later).

The performance monitoring period is normally about a one or two year period, during which the facility’s operation is monitored.  Its performance is compared to what was expected, given the available solar/wind/other resources, and the Contractor is liable to compensate the Employer for any underperformance.

The method of determining the amount payable is carried out upfront, through the calculations specified in the contract for Performance Liquidated Damages.

PLDs should:

  • Be reflective of the losses incurred by the Employer for any facility underperformance
  • Be sufficient to compensate the Employer for the facility’s operational life (say 20 years)
  • Be a good balance between compensating the Employer without increasing the contract price to an excessive level
  • Not double-penalise the Contractor for any reduction in installed capacity, if there has already been an adjustment to the contract price, pre-COD
  • Clearly reflect any cap on PLDs that may apply (note there may be an aggregated cap on both PLDs and DLDs)

Lastly, as with DLDs, the Employer should be incredibly cautious of engaging in any activities during the Contractor’s execution of the works that may be construed as a direct request or order, which may be argued to have impacted on the facility’s performance.  While the Employer may choose to have close involvement during the project, the decisions made in designing and constructing the facility are up to the Contractor, and any direct instructions (not relating to H&S or environmental compliance issues) should be avoided wherever possible.