GAME THEORY IN WIND POWER CONSTRUCTION CONTRACTS
Mar 23, 2015
Building an onshore or offshore wind farm is a highly complex process which is reflected in the project contracts. Whatever the contract structure is (Turnkey/EPC or Multi contract/split delivery), risk factors remain core issue.
The industry practice is to use international contract templates such as FIDIC. They are a great tool as they are based on accumulated project experience, the structures are well known to the stakeholders (investors, contractors and financiers), and they usually provide a balanced risk allocation.
Why we fight then?
Having said the above, I have experienced an interesting contradiction.
In many cases, after countless hours of fierce contract negotiations I have asked myself: What is the ultimate purpose of the contract? Is it to achieve the highest possible compensation in case of defaults and shift the risk to the other party? Or the goal is to have an operational power plant build on time and within budget?
For sure many of you who have been involved in contract negotiation and execution can relate to this situation.
The reason behind this is that most of the contracting templates are focused on detail risk allocation and managing the consequences of risk, rather than on risk avoidance and issue resolution. The other shortcoming is that traditional contracts treat change as anomaly (just think of Variation Order procedures under FIDIC). Such contracts try to predict and specify every possible case. That would have been sufficient if the real world was not so dynamic and the projects where executed on the same table where the contract was signed (and not in the field or at the sea).
Real world is dynamic. When changes occur the traditional contracts do not focus enough on cooperation which is necessary to deal with the changes and solve problems before they get out of control. Successful contract execution does not depend so much on what the parties have drafted in the contract but rather on the way they handle difficulties during the course of the project.
Contracting is not a game, but game theory applies
Before we can look into the different ways of solving this phenomena, we need to understand some basic principles first. Let’s analyze the contracting process nature using game theory definitions:
A) Construction contracts are not a zero-sum game. In this type of projects we rarely face a situation where one party’s gain is equal to the other’s party loss. Think of turbine Defects Liability for example. The gain that the Employer (Owner) may receive as compensation may be higher than the actual loss of the Contractor (and vice-versa).
B) It is not a competitive but a cooperative game. The main goal of the contract is to set the terms for building a power plant. The parties need to cooperate in order to achieve that. In this sense they are a “coalition” with common interest.
C) There is no antagonism. Antagonism is present when one of the parties aims not only in maximization of its own payoff function, but also in minimization of the other’s party payoff. Image a situation where the Employer’s negotiation strategy is to achieve not only the most profitable project, but also the lowest margin for the Contractor. One can guess the consequences of that.
With the above in mind we can say that the wind construction contract negotiation and contract execution represent a non-zero-sum, cooperative process where both parties have a common goal: successful project completion.
How to achieve that goal?
Cooperative games emphasize participation and problem solving. In contracting terms this can be enforced by gainshare/painshare structures. Here are two of the possible ways to materialize that.
- Adjust the FIDIC terms to include real incentives
- Use Relational Contracting (Project Alliancing)
>> One example of this is the so called “early completion bonus” in FIDIC templates. If set properly it can be a real “gainshare” factor. The important thing is to agree on a sufficiently high amount that can be actually gained by the Contractor on early completion. If the bonus seems too vague or practically impossible to get, then the incentive is not real. (Example: The Employer promises a share of early generation revenues while it is known upfront that “early generation” is not feasible under the PPA conditions).
>>Play “open-book” on certain items. This is valid approach especially in cases where for some reason the main Contractor is forced to include certain additional scope that is not core part of its business. (Example: if you include foundations in the scope of a wind turbine manufacturer it may be wiser to split this portion on actual cost + profit, rather than agreeing on a lump sum containing too high contingencies.)
Relational contract theory looks at contracts as relations rather than as discrete transactions. A practical example is the so called “Project Alliancing”. It handles risk completely different from standard contract. Risk is shared and not allocated between the parties. The focus is on cooperation vs. blaming the other, open communication, teamwork and incentives to innovate which in turn stimulate decision making that is best for the project (vs. best for the single party).
The Project Alliancing concept was developed by BP during the 90s for projects in the offshore oil exploration field. Here are its main characteristics:
>> Collaborative target cost development. After careful contractor selection procedure, all parties sit together and develop the so called optimized “target cost”. This is different from the standard approach where bidders are asked to offer the most competitive price based on pre-defined terms & conditions. The rationale behind that is the following: Employers often use the contract as “legal protection” in attempt to shift most of the risks to the contractor using harsh contract clauses. Larger contractors in turn are trying to pass the risk to smaller subcontractor who may not have the financial backing to cover it. Further, harsh contracts discourage responsible bidders and attract bidders that are willing to take any kind of risk. Therefore a competitive bidding process does not necessarily lead to the best possible outcome. The cost level achieved in this process is also far from certain.
>> Uninsurable risk is shared between the parties (and not allocated/split between them).
>> Participant are paid based on an open-book model consisting of guaranteed fees, corporate overhead and profit (the maximum amount the participant can lose for target cost overruns) and a predetermined gainshare/painshare portion depending on the final cost vs target costs.
>> Project is governed by an Alliance Board that takes unanimous decisions.
>> Project management team that handles daily issues is formed by participants from all parties.
>> Disputes are handled internally with litigation left as last resort.
Is it really working?
The above may sound too good. Indeed, the Project Alliancing approach has proven as successful in the oil industry as well as in many Public Private Partnerships.
However, when we talk about wind power projects we need to consider the fact that most of them are financed on a non-recourse project finance scheme (compared to balance sheet financing). Lenders, among other things, require CAPEX certainty.
Therefore one of the main question is: Can you convince them that a cooperation and incentive based contract will give a lower, far more certain cost level than the traditional approach? And is it better to have a fixed values in your spreadsheet or a de-risked contract that results in higher chance for timely project completion?
- ETRM: WHERE’S THE FUN IN NATURAL GAS? (1,333) views
- INTERRELATIONSHIP BETWEEN CONCESSION AGREEMENTS AND… (1,280) views
- GAME THEORY IN WIND POWER CONSTRUCTION CONTRACTS (1,217) views
- CHALLENGES IN CROSS-COMMODITY SYSTEM IMPLEMENTATIONS (1,151) views
- WHAT DOES YOUR ETRM SYSTEM ALLOW YOU TO HEDGE WITH? (901) views
- HEDGE ACCOUNTING OR ACCOUNT FOR HEDGING? (800) views
- WIND DERIVATIVES – A BET OR A HEDGE? (762) views
- ROITI TAKES ITS POWER TO A NEW LEVEL (759) views
- E-WORLD 2015: LESSONS FROM ESSEN (712) views
- EXPERTS PUT SOFTWARE ON TOP OF THE ENERGY BUSINESS AGENDA IN (675) views
- Gas Storage – Always a Good Challenge
- Gas Capacity Medley
- NEW GAS MARKETS FOR ENERGY TRADERS – NEW ETRM TRICKS NEEDED
- WIND DERIVATIVES – A BET OR A HEDGE?
- Achieving a Reliable Front Office Reporting in ETRM systems: Typical Pitfalls
- RES support tenders – increasing competition or emergency brake?
- Navigating the EU State Aid rules, when implementing a capacity mechanism
- Will UK power capacity market face shortage?
- End-Of-Day made simple: Mission impossible?
- HEDGE ACCOUNTING OR ACCOUNT FOR HEDGING?
- OVER SUPPLIED BUT SHORT OF GAS – YOU ARE PROBABLY ITALIAN!
- MAR AND HOW DOES IT FIT IN THE REGULATORY FRAMEWORK OF THE EUROPEAN UNION