In a typical construction project financing transaction, the project company is a special purpose vehicle (SPV) created for the project’s unique goals.
If the project firm is an SPV, it is unlikely to have the skills to manage or maintain the project on its own, thus it will sign into an Operation and Maintenance (O&M) Contract with a suitably-qualified contractor (the O&M Contractor) to offer these services.
The objective of a Contract for O&M is to:
- assign operating risk to the entity best positioned to assume it, namely the O&M Contractor
- guarantee that there are defined criteria for evaluating the effectiveness of the project and that, if goals are reached, the project firm will produce sufficient profits; and
- control operational and maintenance expenditures
The Operation and maintenance (O&M) contract has a substantial impact on the outcome of any project finance transaction, as it is one of the most important contracts. In this article, operation and maintenance contract, we take a look at the process involved and the options available to you.
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What are the first things to consider with an O&M contract?
When considering operation and maintenance, it should be readily clear whether the contractor is also involved in the project in another capacity. Under the terms of the engineering, procurement, and construction (EPC) contract, for instance, does the contractor belong to the same business group as the construction provider?
If so, the interface between the O&M and the EPC must be considered and back-to-back provisions must be included in each contract to prevent the contractor and the construction provider from relying on:
1) the acts or omissions of the other as a defence to its own delay or non-performance of the relevant contract; or
2) delays or underperformance by the other to obtain relief from the customer under the relevant contracts.
Inattention to the integration of the front end legal terms and the services scope indicated in the O&M schedules can lead to a mismatch between the parties’ service expectations and, in the worst-case scenario, a full disagreement that results in a lawsuit. This is because the definition of the contractor’s services responsibilities will be complex and need project-specific technical expertise, which must be encased in acceptable legal terms.
Owners obligations
The owner’s principal obligation during the life of the contract should be to pay the operator. If at all practicable, payment shall be limited to specified quantities and will be made from the proceeds of the offtake agreement.
The provision of energy, fuel, water, and other consumables are likely to be extra significant ongoing obligations. Moreover, the contract shall establish any additional requirements applicable to the Owner. For example, the owner may be obligated to provide an initial supply of spare components (which should be identical to the inventory of spare parts to be delivered by the contractor under the building contract). In addition, the offtake agreement may require the owner to maintain records regarding the operator’s compliance with certain items (such as fuel use and waste disposal), which may have an influence on the owner’s payment obligations under the contract. Payment procedures should also be included in the contract (such as mechanisms for payment of owner-supplied spare parts, major overhaul expenses, costs resulting from work performed by the operator outside the scope of services described in the contract, changes in the law, and other potential factors that may necessitate adjustments to payment provisions).
Performance obligations
The contract shall specify the performance requirements for the operator during the term of the Agreement. Depending on the nature of the project, the performance specifications should typically include availability, outages, production levels, and additional technical, quality, safety, and environmental protection performance standards. The contract shall also specify the levels of performance that may give rise to damages and/or termination rights if performance falls below a predetermined threshold. In some situations, there may also be a gain share mechanism that rewards operators whose performance exceeds a specific threshold with bonuses. In addition, the performance levels achieved by the construction contractor at the time of handover should be indicated. With suitable modifications (such as degradation curves), these values should serve as a baseline for the performance expectations of the operator. Moreover, on a power project, for example, it is essential that the technical and legal advisers confirm that the performance testing and performance guarantee and liquidated damages schedules of the agreement are consistent with the appropriate schedules of the construction contract.
Mechanisms for payment, incentives, and liquidated damages
The payment method in an O&M contract can be structured in a number of different ways. In most cases, the operator is reimbursed with a combination of a fixed charge and reimbursement.
Priority number one for the project company and the financial institution is the management of O&M expenses. The most effective way for them to achieve this would be to agree on a fixed cost for operating and maintaining the facility. However, this is rarely accepted by operators and is unlikely to provide the best value. Important to the payment arrangements is the operator’s incentive to maximise the project’s revenue. Typically, this is accomplished by granting the operator more remuneration or a bonus for exceptional performance.
Typically, an operator will be forced to pay liquidated damages to the project firm if it performs poorly and fails to operate or maintain the project in accordance with the agreed-upon criteria. Typically, these payments are established so that the project firm may fulfil any responsibilities arising from the concession contract or offtake agreement. However, these are frequently limited to a fraction of the O&M operator’s costs. The execution of the liquidated damages regime is dependent on the project’s characteristics.
Impact Of Force Majeure
A important consideration is whether the contract adequately handles the consequences of a force majeure occurrence.
During the negotiation of project contracts (where the owner’s obligations are mostly limited to payment, as in operation and maintenance agreements), force majeure clauses should be standardised throughout all contracts. If these clauses are not aligned and the owner retains major liability gaps, lenders will often want some form of sponsor support.
Even a prolonged force majeure situation will simply increase construction costs and delay completion. This risk can be allocated among project participants prior to project launch and accounted for while evaluating the project’s economics and contingencies.
However, a prolonged occurrence of force majeure during operation time may result in an insurmountable obstacle. Even if the operator were ready to increase its financial commitment, which is typically not the case, it may be unable to fulfil the performance level set in the contract. This will directly influence sales.
Indemnities
As with other commercial contracts, indemnity clauses are common in O&M contracts and play an important role in transferring risk between the operator and the project company. A contractual commitment to bear responsibility for another’s loss is an indemnification. It is applicable as a risk allocation approach when one party produces a risk that causes the other party to suffer or incur a loss due to a third-party claim. However, indemnities are not restricted to claims by third parties; a party may agree to indemnify the other party for the consequences of the first party’s breach of contract.
There are numerous indemnity clauses, and the specific wording of an indemnity clause is significant since it affects its scope and the amount of the remedy. An indemnity may cover a wide range of subjects. For example, it may cover only third-party claims, “all losses” stemming from any claim relating to the subject matter of the contract, or only those resulting from a specific range of services. Typically, an indemnity covers death, injury, or disease to individuals, property damage, and other consequential losses; however, it is essential to specify which losses are intended to be included or excluded under each of these categories.
One of the fundamental functions of indemnities in O&M contracts is to protect the indemnified party from the risk of third-party claims resulting from the indemnifier’s violation. The indemnity clauses must take into account the nature of the operations and maintenance, the potential hazards, and the expertise required to handle these risks. Indemnities may be of limited or no value if the indemnifier lacks sufficient assets to back the indemnity; hence, insurance coverage is also essential. However, not all risks covered by an indemnity are insurable, and the ability of each party to endure any potential loss is an essential consideration.
How we can help
We have a proven track-record of dealing with operation and maintenance contracts. Not only does our construction department have extensive legal experience and knowledge of construction law but we also have the benefit of chartered surveying experts. We will guide you through the process and ensure all checks are carried out swiftly and efficiently and we firmly believe that with the right solicitors by your side, the entire process will seem more manageable and far less daunting.
How to Contact Our Construction Solicitors
It is important for you to be well informed about the issues and possible implications of operation and maintenance contracts. However, expert legal support is crucial in terms of ensuring a positive outcome to your case.
To speak to our Construction solicitors today, simply call us on 0345 901 0445, or click here to make a free enquiry. We are well known across the country and can assist wherever you are based. We also have offices based in Cheshire and London.
Disclaimer: This article provides general information only and does not constitute legal advice on any individual circumstances.
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