Gaining Certainty When Contracting to Construct New Nuclear Plants

Robert Temple, Deputy General Counsel, CPS Energy

THIS ARTICLE PROVIDES ONE UTILITY lawyer's views on considerations when contracting to build a new nuclear power plant. In a period of increasing uncertainty regarding escalation of equipment costs, commodity prices and labor rates, the following article provides pointers that may help utilities drive out some uncertainties around contracting to build a new nuclear power plant in today's environment.

Tip #1: Own the rights to the information developed for your project's COLA

For these projects to get to square onethe submittal of a combined construction and operating license application (COLA) to the U.S. Nuclear Regulatory Commission (NRC)the project developer, who we will call the utility, must have a contract for COLA development with one of the major reactor vendors or a vendor capable of developing a COLA for a certified reactor design. The utility may leave it to the reactor vendor to contract with the host of subcontractors needed to develop the COLA as the COLA includes requirements for area environmental, soils, metrological, and even cultural information that a reactor vendor is ill-equipped to provide.

No matter how the utility contracts at this stage, it needs to retain absolute rights to the information that is developed for its COLA. That may mean a perpetual license to use that information, if it is intellectual property owned by the reactor vendor, or an absolute right to own site-specific information. Whatever the approach, it is important that the initial COLA contracts don't make a utility the hostage of a reactor vendor. Clearly the COLA is technology-specific, so if the utility cannot come to terms on an engineering procurement construction (EPC) contract with a particular vendor, the utility may have to walk away from some vendor-specific COLA work. Keeping this in mind suggests that it is more important to try to get to a definitive contract earlier than later in nuclear project development.

Tip #2: Manage your risk effectively—Decide up front which counterparties will be accountable and liable for what part of the project

Early in the discussions with the reactor vendor, the utility needs to understand who the counter-party in an EPC contract will be and what risks that counter-party is willing to assume. Will the reactor vendor want to act as prime contractor; will the constructor act as prime contractor; or will the utility deal with a consortium that will include the reactor vendor and constructor? No matter the counter-party, the utility cannot be put in the position of having to guess who is accountable for a problem. It is best that one entity (vendor or consortium) is liable (or jointly and severally liable).

Once the COLA work is under way, it is time to negotiate the EPC contract or a pre-EPC contract for the long-lead materials and up-front engineering, or both. It seems that it is easier to manage the relationship if essential terms are negotiated once, early in the project. The utility may be put into a difficult position if substantial work is done under a pre-EPC contract and it is not able to come to terms on the final EPC contract. The question is: how can the parties share the risks equitably at each phase of the project—to keep the reactor vendor/constructor engaged in and committed to successful project completion while having the utility assume a measured amount of the risk?

Tip #3: Build in "hold backs" to keep the vendor committed to successful project completion

From the reactor vendor's/constructor's vantage, it is using resources on a project that it cannot use on another. If the "real" profit is to be made at the back end of a project, that can keep the vendor committed to the project. But, what if the utility takes a project "off-ramp" and stops project development early? Utilities must have these "off-ramps" in case the loan guarantees or other financing requirements cannot be met or in case a change in law makes further development of a project imprudent. At the same time, it is important to have some hold-back in the project up-side for the vendor to keep it committed to the project. Some utilities have discussed tying compensation bonuses set early in the pre-EPC phase not only to schedule and performance, but also to a target price. Others opt to have retainage and set a release point for a certain part of that retainage when the price is set. Whatever the scheme, there should be a benefit for staying in the game and an obligation for the vendor to deliver what is needed for the project. That is probably easiest to manage under a single contract.

Tip #4: Manage the pricing structure and build in incentives to complete the project in line with or below the initial agreed upon price

Most companies experienced in building power plants are unwilling to enter into a firm, fixed-price, fully "wrapped" project contract or such a contract would be priced so ridiculously high that the project would never get built. The sales people will give a price that sounds nice but likely has nothing to do with reality. In the early stages of a project the vendor may be willing to offer an "indicative price." If there is no risk or reward associated with that price, is that estimate any more valuable than the one that the sales team provided? There is greater value if the indicative price is tied to some form of reward or penalty if the final plant price is below or above this indicative price. It is equally important to get at the details behind the indicative price so the utility can determine whether this price is merely an opening bid, from which the plant price will escalate, or whether it is a realistic attempt to issue a price based on an understanding of the labor hours, equipment costs, and volume of commodities that are likely to go into the plant.

If in possession of the detailed underlying assumptions that go into an indicative price, the utility can determine whether the estimates are realistic. This review will provide a basis for testing the assumptions in the indicative price. Questions will remain—who is taking escalation risks (labor, commodities); what are the owner's costs in addition to the vendor-supplied price; what is included in the price; what sort of inflation and escalation assumptions are part of the price? All of these issues should be known to estimate what the real starting point is for the project.

But, how does a utility get to the "real" price? The approach that some utilities and vendors are advocating today is by using an "Open Book." The Open Book is the vendor's project ledger, which should be completely transparent to the utility as long as the project is in its Open Book phase. Initially, all long-lead procurement and early phase engineering is done on a real cost of materials and time basis, without mark-up. The utility can see bid specifications for equipment, the qualified vendors who receive bids and the "scoresheets" used to select the winning bidder. The utility will be responsible at this time for reservation fees and have cancellation risk should it abandon the project. In addition to reservation fees, in order to establish specifications for the major equipment, the volume of commodities, and the labor hours to erect the plant, the utility will need to fund early engineering costs. The objective is to reduce uncertainty around material needs and equipment specifications and other variables in the project. The Book cannot be closed until prices have been locked down on major pieces of equipment, the volume of commodities and labor hours are "known," and the costs associated with commodities and labor have been "set." From that point forward, the project should be completed on a "Closed Book" basis, with the total cost of the project fixed, with rewards or penalties for making the price set when the Book was closed.

The utility has paid reservation fees, took on cancellation risk, and paid for engineering on something approaching a time and materials basis during the Open Book period. How does the utility pay project costs once the Book gets closed? The estimating period is a great time to also develop a schedule of values or detailed milestones with objective criteria that must be met for a payment to be issued. If payments are just on a schedule without a requirement for the vendor to demonstrate project progress to get paid, the utility may pay the entire project price and not have an operating plant to show for it.

Tip #5: Set aside a retainer to secure access to the vendor's money in the event of performance failure

In addition to dealing with the tactical issues associated with getting to a price, the engineers will want to know that the plant is going to be delivered on time and perform as designed. The lawyers will want to know who is accountable and the extent that they can be held accountable. Limits on liability should be tied to the utility's real costs for schedule or performance failures. Should a schedule delay be priced at the cost that the utility would forgo if it sold electricity into its market, at the cost of replacing the power, or at the cost of capital for carrying the project while a schedule delay exists? All of these are considerations. In addition, is the utility going to ask for retainage, a letter of credit, or some other form of guarantee? Utilities are best served by having direct access to the vendor's money for performance failures without having to issue notice or get consent to get at funds set aside for a guarantee. Utilities understand the adverse impact of drawing down on such funds and they are unlikely to take such a step lightly.

Tip #6: Financing success often depends on spreading risk between the utility and contractor vendor

"Can this deal get financed?—"the answer is, "it depends"… a bank should be looking at the utility's term sheet and EPC contract structure to weigh in on issues important to financing. If the utility is planning on relying on the DOE Loan Guarantee Program, there are program criteria that also should be considered. In a major construction project, the project developer always carries the greater risk. If there is a disproportionate amount of risk forced onto the owner, however, the transaction won't get financed. If the vendor assumes risks that it cannot be realistically counted on to cover, the deal will also not get financed.

Conclusion: Pigs get fat, hogs get slaughtered.

The new reactor licensing process is designed to bring greater certainty to the regulatory review and licensing process; so long as a utility builds a certified design, the NRC won't backfit changes to the licensed design except in dire circumstances. If regulatory uncertainty is gone, what remains? The vendor and utility must get to a contract that provides a reasonable sharing of the project's risks and rewards. If new nuclear power plants are going to be built in an environment with increasing costs for generation, vendors and utilities must be willing to work together to get to a deal rather than scrapping for the last dollar. If any deals are going to get done, they must be structured such that they are financable and allocate risk reasonably. If vendors and constructors are unwilling to assume risk commensurate with their responsibility, these plants will not get built.