Review

This article identifies key performance clauses that are commonly included in EPC (engineering, procurement and construction) contracts for wind farm projects, concentrating on the important role liquidated damages provisions play in EPC contracts. Provisions imposing delay liquidated damages and performance liquidated damages must reflect the unique performance and testing regime applicable to wind farm projects. After surveying this performance and testing regime, the article highlights numerous technical issues that need to be addressed in a comprehensive wind farm EPC contract.

Rationale for imposing liquidated damages

Almost every construction contract will impose liquidated damages for delay and impose standards for the quality of construction. However most do not impose performance liquidated damages. Engineering, procurement and construction contracts impose performance liquidated damages because the achievement of the performance guarantees significantly impacts on the ultimate success of a project. Similarly, it is important that the wind farm starts operating on time because of the impact on the success of the project and because of the liability the project company will have under other agreements, This is why delay liquidated damages are imposed. delay liquidated damages and performance liquidated damages are both “sticks” used to motivate the contractor to fulfil its contractual obligations.

The law of liquidated damages

Liquidated damages must be a genuine pre-estimate of the project company’s loss. If liquidated damages are more then a genuine pre-estimate they will be a penalty and unenforceable. There is no legal sanction for setting a liquidated damages rate below that of a genuine pre-estimate; however, there are the obvious financial consequences.

In addition to being unenforceable as a penalty, liquidated damages can also be void for uncertainty or unenforceable because they breach the prevention principle. If it is not possible to determine how the liquidated damages provisions work, then a court will declare the provisions void.

The prevention principle was developed by the courts to prevent employers, namely project companies, from delaying contractors and then claiming delay liquidated damages. It is discussed in more detail below in the context of extensions of time.

Before discussing the correct drafting of liquidated damages clauses to ensure they are not void or unenforceable it is worth considering the consequences of an invalid liquidated damages regime. If the EPC contract contains an exclusive remedies clause the result is simple: the contractor will have escaped liability unless the contract contains an explicit right to claim damages at law if the liquidated damages regime fails.

However if the EPC contract does not contain an exclusive remedies clause the non-challenging party should be able to claim at law for damages they have suffered as a result of the challenging party’s non- or defective performance. What then is the impact of the caps in the now invalidated liquidated damages clauses?

Unfortunately, despite judicial pronouncement, the position remains unclear in common law jurisdictions, and a definitive answer cannot be provided based upon the current state of authority. It appears that whether common law damages are recoverable varies depending upon whether the clause is invalidated due to its character as a penalty, or because of uncertainty or unenforceability.

Clause invalidated as a penalty

When liquidated damages are invalidated because they are a penalty (ie they do not represent a genuine pre-estimate of loss), the liquidated damages or its cap will not act as a cap on damages claims at general law.¹ We note that it is rare for a court to find that liquidated damages are penalties in contracts between two sophisticated, well advised parties.

Clause invalidated due to acts of prevention by the principal

A liquidated damages clause will cap the contractor’s liability where a liquidated damages regime breaches the prevention principle because this gives effect to the commercial bargain struck by the parties.

Clause void for uncertainty

A liquidated damages clause which is uncertain is severed from the EPC contract in its entirety, and will not act as a cap on the damages recoverable by the principal from the contractor. Upon severance, the clause is ignored, for the purposes of contractual interpretation.

However, it should be noted that the threshold test for rendering a clause void for uncertainty is high, and courts are reluctant to hold that the terms of a contract, in particular a commercial contract where performance is well advanced, are uncertain.

Drafting of liquidated damages clauses

Given the role liquidated damages play in ensuring EPC contracts are bankable, and the consequences detailed above of the regime not being effective, it is vital to ensure they are properly drafted. If properly drafted they will ensure contractors cannot avoid their liquidated damages liability on a legal technicality.

Therefore, it is important, from a legal perspective, to ensure delay liquidated damages and performance liquidated damages are dealt with separately. If a combined liquidated damages amount is levied for late completion of the works, it risks being struck out as a penalty because it will overcompensate the project company. However, a combined liquidated damages amount levied for underperformance may undercompensate the project company.

Our experience shows that there is a greater likelihood of delayed completion than there is of permanent underperformance. One of the reasons why projects are not completed on time is contractors are often faced with remedying performance problems. This means, from a legal perspective, if there is a combination of delay liquidated damages and performance liquidated damages, the liquidated damages rate should include more of the characteristics of delay liquidated damages to protect against the risk of the liquidated damages being found to be a penalty.

If a combined liquidated damages amount includes a net present value or performance element the contractor will be able to argue that the liquidated damages are not a genuine pre-estimate of loss when liquidated damages are levied for late completion only. However, if the combined liquidated damages calculation takes on more of the characteristics of delay liquidated damages the project company will not be properly compensated if there is permanent underperformance.

It is also important to differentiate between the different types of performance liquidated damages to protect the project company against arguments by the contractor that the performance liquidated damages constitute a penalty. For example, if a single performance liquidated damages rate is only focused on availability and not efficiency, problems and uncertainties will arise if the availability guarantee is met but one or more of the efficiency guarantees are not. In these circumstances, the contractor will argue that the performance liquidated damages constitute a penalty, because the loss the project company suffers if the efficiency guarantees are not met is usually smaller than if the availability guarantees are not met.

Drafting of the performance guarantee regime

Now that it is clear that delay liquidated damages and performance liquidated damages must be dealt with separately, it is worth considering, in more detail, how the performance guarantee regime should operate. A properly drafted performance testing and guarantee regime is important because the success or failure of the project depends, all other things being equal, on the performance of the wind farm.

The major elements of the performance regime are:

• testing
• guarantees
• liquidated damages.

Liquidated damages were discussed above. Testing and guarantees are discussed below.

Testing

Performance tests may cover a range of areas. Two of the most common are functional tests and guarantee tests.

Functional tests - these test the functionality of certain parts of the wind turbine generators. For example, SCADA systems, power collection systems and meteorological masts etc. They are usually discrete tests which do not test the wind farm as a whole. Liquidated damages do not normally attach to these tests. Instead, they are absolute obligations which must be met. If not, the wind farm will not reach the next stage of completion (for example, mechanical completion or provisional acceptance).

Guarantee tests - these test the ability of the wind farm to meet the performance criteria specified in the contract. For instance, a requirement to meet a specified power curve or an availability guarantee to meet the minimum quantity of electricity required under the power purchase agreement. The consequence of failing to meet these performance guarantees is normally the payment of performance liquidated damages. Satisfying the minimum performance guarantees is normally an absolute obligation. The performance guarantees should be set at a level of performance at which it is economic to accept the wind farm. A lender’s input will be vital in determining what this level is. However, it must be remembered that lenders have different interests to the sponsors. Lenders will, generally speaking, be prepared to accept a wind farm that provides sufficient income to service the debt. However, in addition to covering the debt service obligations, sponsors will also want to receive a return on their equity investment. If that will not be provided via the sale of electricity because the contractor has not met the performance guarantees, the sponsors will have to rely on the performance liquidated damages to earn their return. In some projects, the guarantee tests occur after hand over of the wind farm to the project company. This means the contractor no longer has any liability for delay liquidated damages during performance testing.

In our view, it is preferable, especially in project financed projects, for handover to occur after completion of performance testing. This means the contractor continues to be liable for delay liquidated damages until either the wind farm achieves the guaranteed level or the contractor pays performance liquidated damages where the wind farm does not operate at the guaranteed level. Obviously, delay liquidated damages will be capped (usually at 20% of the contract price). Therefore, the EPC contract should give the project company the right to call for the payment of the performance liquidated damages and accept the wind farm. If the project company does not have this right, the problem mentioned above will arise, namely, the project company will not have received its wind farm and will not be receiving any delay liquidated damages as compensation.

It is often the case in wind farm projects that the contractor or operator of a wind farm will not accept liability for availability PLDs beyond a limited period. In a power plant, the performance liquidated damages are calculated to enable the owner to recover the amount it will lose over the life of the power plant in the event either the heat rate, rated output or availability guarantees are not satisfied. The performance liquidated damages on a power plant are usually calculated using the net present value of the owner’s loss based on the life of the plant. On wind farm projects, the contractor will pay power curve performance liquidated damages but will often not accept responsibility for availability performance liquidated damages beyond the warranty period or in the case of the operator, the term of the operating and maintenance agreement. The contractor or operator, as the case may be, will simply pay the yearly availability performance liquidated damages for failing to meet the stipulated availability guarantee over the warranty period specified in the contract or for the period during which the operator has control over the operation and maintenance of the wind farm.

It is common for the contractor to be given an opportunity to modify the wind farm if it does not meet the performance guarantees on the first attempt. This is because the performance liquidated damages amounts are normally very large and most contractors would prefer to spend the time and the money to remedy performance instead of paying performance liquidated damages. Not giving contractors this opportunity will likely lead to an increased contract price because contractors will build a contingency for paying performance liquidated damages into the contract price. The second reason is because in most circumstances the project company will prefer to receive a wind farm that achieves the required performance guarantees. The right to modify and retest is another reason why delay liquidated damages should be payable up to the time the performance guarantees are satisfied.

If the contractor is to be given an opportunity to modify and retest the EPC contract must specify who bears the costs required to undertake the retesting. The cost of the performance of a power curve test in particular can be significant and should, in normal circumstances, be to the contractor’s account. This is because the retesting only occurs if the performance guarantees are not met at the first attempt.

Technical issues

Ideally, the technical testing procedures should be set out in the EPC contract. However, for various reasons, including it often being impossible to fully scope the testing program until the detailed design is complete, the testing procedures are usually left to be agreed during construction by the contractor, the project company’s representative or engineer and, if relevant, the lenders’ engineer. However, a properly drafted EPC contract should include the guidelines for testing.

The complete testing procedures must, as a minimum, set out details of the following.

• Testing methodology - reference is often made to standard methodologies, for example, the IEC 61-400 methodology²
• Testing equipment - who is to provide it; where it is to be located; how sensitive must it be?
• Tolerances - what is the margin of error? For instance, should wind conditions in excess of certain speeds be excluded?
• Ambient conditions - what atmospheric conditions are assumed to be the base case (testing results will need to be adjusted to take into account any variance from these ambient conditions)?

In addition, for wind farms with multiple wind turbine generators the testing procedures must state those tests to be carried out on a per turbine basis and those on an average basis.

Footnote

¹ Cf Fraser v Evans [1946] VLR 382.

² The International Electrotechnical Commission (IEC) is a global organisation that prepares and publishes international standards for all electrical, electronic and related technologies. The main technical committee for wind turbine systems is TC88 which publishes standards for the wind turbine industry.