A Typical Project

For the purposes of this paper, let’s pose a $1.2 billion, 600 MW coal-fired project (excluding financing costs). Let’s say that this is composed of $780 million for equipment, $360 million forconstruction work and startup, and $60 million for engineering. In today’s world of contracting, these costs will not remain constant. Based on various industry studies, they will most likely increase at double-digit rates for the next few years unless some special approaches are taken, during the development of the project itself. But what are those approaches, and how can they be implemented in time to avoid the cost spiral so many are experiencing?

To get a better feel for this, let’s look at an EPC project in its three phases: 1) Engineering, 2) Procurement, and 3) Construction. Let’s look at what some in the power plant, and other industrial construction businesses are doing, or are talking about doing.

EPC

First, the overall EPC concept. Owners, lenders and contractors are now evaluating each other’s strengths and weaknesses with much more emphasis on each one’s ability to manage risk. Responsibilities are being assigned based on these strengths and weaknesses. For instance, when the owner has a strong engineering and procurement staff, an EPC contract is not always the most cost effective approach. However, most owners do not have sufficient in-house staff to tackle large coal-fired projects, so they turn to some manner of EPC contracting.

One approach that is gaining favor is the “open book” EPC approach. Here, the goal is to keep the contract scope and price open until the design can be fully defined and the equipment clearly specified, bid and ready to award. This allows the EPC contractor more time to scope and price the work, thereby reducing his risk and therefore his ultimate price. Then, the EPC contract can be either firmed up, or it can continue on an open-book target price basis. However, whether the work is performed under a single lump-sum EPC contract, or a split responsibility arrangement, the E, the P and the C must still be performed. The following is a discussion of each of these along with approaches currently being used by some to control the cost spiral.

Engineering

Although the engineering component of the project cost generally is very small, decisions made during the engineering phase will affect everything else downstream of it. One of the major contentions is often the issue of “over-engineering”. This is analogous to designing a Cadillac when a Chevrolet will do. So first and foremost, how are some owners reigning in the engineer? During the initial planning phase of the project, owners look at the issues that drive engineers, especially engineering firms. Why are these firms in business? What do they have to do to stay in business? They are in business to make money, and they make money by generating manhours. They stay in business on the reputation of their previous work – pointing out their beautiful (Cadillac) designs of the past.

So during the engineering selection process, some owners now look to either forming an alliance with an engineering firm or entering into a bonus/penalty or incentive based contract. An alliance relationship can be structured with a fee being tied to the final cost of the project. If the project costs more than originally budgeted, the engineer risks his fee. Under budget and he gets more fee. A similar scenario can be developed by using a penalty and/or bonus arrangement. The emphasis is on an engineering fee, not the manhours billed. Some contracts now are structured in a way that the engineering manhours are no longer the driver. The driver is some type of fee. And finally, the engineering work may also be structured to have a very clear cut-off date, a date after which no changes are allowed, unless they are field requested or required. But for this to be successful, an upfront commitment must be made to manage the engineer.

Even if the engineering contract (or the total EPC contract) is firm lump-sum, it must be managed by the contracting party. Too many projects are engineered on change orders. Change orders add cost to the project, and they usually occur when there’s little opportunity to do anything about it. A dedicated manager for the engineering contract, from beginning to end, is a small investment compared to the cost impact of just a few change orders that require expedited materials and rework in the field, as the job is reaching critical milestone dates. And a dedicated engineering manager can also keep the design reasonable, not allowing it to mushroom into that Cadillac.

Procurement

The major component of today’s price spiral lies with the cost of materials and equipment. Structural steel prices are constantly escalating. Alloy metals, especially for boiler pressure parts, are in short supply. Copper (hence cable and wire) prices have risen four-fold in the last five years. The cost of cement has gone through the roof and rebar prices are also soaring. Meanwhile, the cost of transporting all of this has also risen, due to the scarcity of vessels and the high cost of fuel to operate them.

Predictions are that this will only get worse. Even though many planned power projects have been shelved or outright cancelled, quite a few will still get built, both in the US and abroad, and that’s part of the problem. It’s the supply and demand issue. Many power plants, and other infrastructure projects, in places like China and India, are drawing resources and materials away from the US market.

An interesting phenomenon is that a significant amount of raw materials and manufacturing capacity is now overseas, in places like China and India. The Catch–22 is that as demand in the US increases, more raw materials and manufacturing capacity is required in these foreign countries to meet the US demand increase, so they will need to increase their own power infrastructure as well. There are some in the industry who call this an impending “train wreck.”

So what is being done to get ahead of this impending train wreck? First and foremost, some organizations are looking to lock in pricing early, e.g. paying to hedge on the price (commodity hedging), or buying up-front. For a new coal-fired power plant, or a major environmental upgrade program, structural steel is always a large component of the material cost. Several owners have already committed to buying some amount of the larger structural shapes and others are seriously considering doing the same, even before the engineering phase gets underway.

Skeptics often ask, “what if the project ends up not being built, and you’ve purchased all of this material?” The response has been that the steel can be resold, and maybe even at a profit. The other questions revolve around design. How can an owner know what size and shape of steel structures should be purchased? The answer to this lies with the engineering phase. Just like dealing with constraints on fuel types and cooling options, the engineer now will be required to deal with the constraints of pre-purchased structural steel shapes as well.

Similar approaches are being taken for alloy tubing required for high temperature pressure parts. Some owners are discussing ways for the manufacturer to keep a predetermined amount of inventory in stock for the exclusive use of the owner. Others are trying to negotiate clearly defined cost escalators. And what happens when these approaches are still not sufficient for guaranteeing the price? Some owners are using surplus materials and equipment – and even buying an extended warranty from the original equipment manufacturer. This is nothing new, it has been done with gas turbine projects for quite some time. It’s just not yet common in the large coal-fired industry.

Normally, the surplus equipment is purchased, renovated and upgraded, and moved to its new location. This can include the equipment support steel, high pressure piping, and even pumps and tanks. In addition to saving on cost, there is often the additional savings of time, since the need to get in line for a manufacturing slot is eliminated. Also, shipment time from a foreign port and clearance through Homeland Security controlled ports is not a factor.So there are ways to lock in the cost of some of the major items to be procured, early in the project. At times, even before the engineering has started.

An additional hurdle we’ve not yet addressed is the issue of the weakened US Dollar. This, in and of itself, has a significant impact on the increase of imported material costs. But again, there are ways to mitigate this. Some owners and large contractors are hedging foreign currency exchange rates by buying forward (currency hedging).

In the end, it’s a matter of calculating the cost. Is it less costly to hedge, buy ahead, lock in price escalators or take a risk on the forces of the market? Or, buy materials and equipment upfront and have the vendor store it. Or, commit with opt-out cancellation fees.

Next week, we conclude this two-part series, as we analyze the “Construction” side of the EPC, and wrap up with some final thoughts on controlling power plant costs.

Source: By Peter G. Hessler - Part #2

To the follow up article, Part #2, click here.