epc industry in india

8/12/2019 EPC Industry in India

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EPC Industry in India: Issues and Challenges| 53 |

EPC Report 4 Cover pages.indd 53 2/20/2011 8


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Chemtech Foreword 2

KPMG Foreword 3

Executive Summary 4

Acronyms Used 4

Methodology 8

Coverage and Scope 8

Setting the Context 10

Value Creation Strategies 17

Key External Drivers and Issues 22

Key Internal Issues 29

End-Use Industry Views 33

EPC Industry in India

Action Agenda for Sustained Growth 48

Acknowledgements 51

About Chemtech 52

About KPMG in India 52

Contents

EPC Report New indd 1EPC Report New.indd 1 2/20/2011 8:2/20/2011 8


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EPC Industry in India: Issues and Challenges | 2 |

CHEMTECH Foreword

Strong infrastructure and industry are critical for India as the country

sees leapfrogging growth. As far as both these sectors are

concerned, India is in a sweet spot, which has created multitude of

opportunities in the fields of engineering, capital goods and construction.

Though, India has witnessed significant investments in both industrial and

infrastructure space, the growth has remained restricted due to various

weaknesses of the Indian EPC industry and difficulties for the foreign players

to ply in the market.

At this juncture, it is an imperative to address the challenges, which restrictthe growth of this sector in India and will continue to repress industrial

development lest addressed.

CHEMTECH has made an attempt to address the issues faced by the

EPC industry through each edition of its international conference, EPC

World Expo. Renowned speakers from world over have deliberated over

the topical issues that must be resolved to accelerate the development of

Indias EPC sector, which would eventually lead to countrys sustainable

economic growth.

As we reach another milestone year with 25th edition of CHEMTECH seriesof expositions and international conferences, Jasubhai Media and KPMG

have come together and taken the initiative address these issues through

this report. I wish to thank all the members of CHEMTECH Advisory Board

for EPC who despite their busy schedules shared their opinions and guided

the team to come up with the study report that aims to leverage the Indian

industry.

We sincerely hope that this report would be a useful information tool for

both industry as well as statutory bodies to gear up for the challenges for

the Indian EPC sector during this decade.

Jasu ShahFounder & Chairman,CHEMTECH Foundation



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KPMG Foreword

The Engineering Procurement and Construction (EPC) services

industry in India is faced with a large and unique opportunity due to

galloping Indian economy, and investments in public and industrial

infrastructure. The 11th five year plan has been an inflection point in

Infrastructure investments, with them contributing upto 9 percent of Indias

GDP.

The 12th plan envisages a total investment in the region of USD 1 trillion,

contributing upto 10 percent of Indias GDP. Similarly, there are large

investments expected in industrial infrastructure, whether it be Oil and Gas,

Metals and Mining and other industries.

This large and fast build out of industrial and plant infrastructure requires

a robust and growing engineering, procurement and construction services

industry for spreading and management of risks, efficiency and productivity

in engineering and construction and supplementing the management

bandwidth of project developers.

This report in line with the theme for Chemtechs EPC conference, takes a

forward looking view on the future of the EPC industry in India, based on

current issues and challenges identified for the industry.

We hope that the collective insights shared in this report contribute towards

shaping future business strategies and government enablement that drive

Indias long term growth in this sector.

Arvind MahajanExecutive DirectorKPMG Advisory Services Pvt Ltd



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EXECUTIVE

SUMMARY

The EPC industry as defined here is

different from the pure engineering

or construction industry. We define

the EPC industry as comprising of

companies who are involved in executing

projects involving multiple engineering

disciplines with overall responsibility for

the performance of a unit or the whole

plant. The scope of work would include

engineering, supplies, construction or

construction management, erection

and commissioning and providing

performance guarantees. The EPC

companies in India are evolving from

multiple routes, with engineering

companies, equipment suppl iers,

construction companies and project

developers morphing in to EPC service

providers by filling in the gaps.

Expectations

As a fa ll ou t of th e US D 1 tr il li on

investment expected in infrastructureand industrial growth keeping pace,

there is heightened interest among the

investor community from engineering

and construction companies who stand

to benefit from this wave. However, the

expectations far exceed the historicalperformance delivered and the EPC

service providers need to step up their

ability to win and deliver business to meet

these expectations.

Similarly, customers now expect EPC

service providers to ramp up theirfinancial and execution capabilities

to be able to execute larger projects,

in time and with ever improving cost

structures.

EPC Engineering, Procurement & Construction

GDP Gross Domestic Product

PPP Public Private Partnership

TSR Total Shareholder Returns

EPCM Engineering,Procurement &Construction ManagementPMC Project Management Consultant

FEED Front End Engineering Design

O&M Operation & Maintenance

JV Joint Venture

BOP Balance of Plant

BTG Boiler Turbine Generator

BOT Build,Operate & Transfer

BOOT Build,Own,Operate & Transfer

DBO Design Build & Operate

DBOOT Design,Build,Own,Operate & Transfer

ITI Industrial Training Institute

MRP Material Requirements Planning

PNGRB Petroleum & Natural Gas Regulatory Board

PCPIR Petroleum,Chemicals & Petrochemicals InvestmentRegions

MENA Middle East & North Africa

CGD City Gas Distribution

ADB Asian Development Bank

JNNURM Jawaharlal Nehru National Urban Renewal Mission

JICA Japan International Cooperation Agency

ULB Urban Local Body

E&P Exploration & Production

Acronyms Used



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Value Creation Strategies and

Routes to Growth

EPC companies can improve their wealth

creation profile by focusing on performance,

prospects and managing risks and financing

costs. While performance is about improving

margins by way of correct estimations,

procurement and project management

capabilities, and focusing on adding higher

margin components to the services provided,

prospects is about continuously adding

newer avenues of revenue growth.

The most likely route for diversification

is through penetration in new end-use

industries or taking the developer route,

which in fact is an imperative for growth in

sectors like Water, Roads involving BOT,

BOOT contracts. International expansion by

EPC companies is likely to be limited largely

due to global competitive intensity and the

large domestic demand.

We expect increasing number of acquisitions

in this industry, as companies look to

enter new end-use industries by buying

qualifications.

Lastly, risk management and no-surprises go

a long way in improving investor perception,

and materially bringing down financing costs

for the EPC companies.



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Key Challenges

The key external challenges faced by the EPC industry are as

follows:-

Continuously evolving contracting models and relatively slower

adoption of the EPC-LSTK concept, especially where customers

are large public sector companies with in-house teams, and large

private sector developers, who have significant in-house project

management capabilities.

Order book uncertainty brought about by purely price based

procurement decision making of customers, which has led to

the emergence of large number of hitherto unknown companies

winning relatively large contracts. While this is essential for capacity

building, it has led to uncertainty of order book for the incumbent

service providers. It also makes making investment decisions more

difficult for companies.

Shortage of skilled manpower for managerial as well as site labour.

The country has its task cut-out in terms of creating skill work force

for the industry. However, the onus really lies on the private sector

and the EPC companies to undertake initiatives to address this

supply-chain issue.

The perception on the sanctity of contracts remains divergent,

especially between Indian companies and International entrants.

There is a need to establish faith in our ability to enforce contracts

by standardization, following international practices and setting

right dispute resolution mechanisms.

External Internal

The key internal challenges are about managing scale and building

capabilities to address issues emanating out of this:-

Project Manager Empowerment, especially in Indian

companies

Balancing speed and cost control in the Procurement

function

Creating a robust engineering organization and balancing

between efficiency and effectiveness

Adoption of leading Risk Management practices

The challenges are accentuated for two sets of companies a)

International entrants and b) mid-size companies looking to scale

up.

Policy making can help mitigate some of the issues related to

enabling private sector for building a skilled workforce, develoing

speedier mechanisms for speedier resolution of contractual

disputes, and clarifying taxation regulations related to the

industry.



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There are macro level learnings to be derived from Koreas EPC

growth story, which may be replicated by the Indian industry

Government support in terms of ministerial oversight for the

industry, followed by active promotion of the industry overseas

Capacity building initiatives in terms of institutions for developing

construction industry talent

Engineering firms working in collaboration with construction

majors, facilitated by not-for-profit engineering industry

associations

Apart from the above, the report discusses specific end-use industry

issues and demand outlook for Power, Oil and Gas and Water,

bringing out nuances in terms of differences in contracting models,

profile of service providers and key challenges.

Learnings from the

Korean Construction Industry



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The report has been prepared by KPMG Advisory Services

Private Limited in association with Chemtech. Leading

executives from the industry were interviewed to seek inputs

for the report. The representation included project developers,

EPC companies, engineering consultants and construction

companies.

We have collected insights based on numerous engagements

with nodal agencies, infrastructure companies, engineering and

construction firms, and foreign players looking to enter India

and equipment suppliers.

Secondary research was conducted using published reports,

news analysis and usage of standard financial databases

subscribed to by KPMG. We have leveraged the expertise and

relationships of our advisory teams in the area of Infrastructure

and Government and Industrial Markets spread across the

country.

Taxation related inputs have been provided by our Tax team

based on their working experience with clients in the area of

infrastructure and engineering and construction.

The report covers primarily the EPC services industry from

the perspective of the following end-use industries - Power,

Refining and Petrochemicals, Water and Water Treatment.

These industries have large investments planned in the country

for the next 5 to 10 years, and involve technological complexity

apart from being complex from a project management

perspective.

Also, they are varied and bring out the nuances of the EPC

sector across most aspects. Specific issues related to EPC

services for other end use sectors like Roads, Railways, Metals

and Mining etc are not detailed as part of this report, though

many of the generic EPC industry issues identified in this report

would also apply to EPC services for these other industries.

Methodology

Coverage & Scope



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EPC or Engineering, Procurement and Construction industry

is referred to by various terms like Construction industry,

Engineering and Construction, Contracting or just engineering

industry. Here we define the EPC industry as consisting of

service providers who are capable of executing projects on a

turnkey basis, including detailed engineering, procurement,

construction, commissioning and performance testing.

We concern ourselves with players who are able to aggregate

multiple engineering disciplines like process engineering,

mechanical, structural, civil and electrical. Examples of such

companies in India are Larsen and Toubro, Punj Lloyd, Tata

Projects, Essar Projects etc. Players who only operate in the

civil construction and structural engineering domain and would

not undertake turnkey construction of a plant or packages

within a plant are not considered as EPC companies by this

definition. It is difficult to draw a strict boundary in terms

of what constitutes an EPC firm vis--vis construction or

engineering firms. One way to distinguish between a classical

EPC company from a primarily civil construction company

is the construction intensity of the end-use sector, defined

by Crisil as the percent of construction spend in the overallinvestment towards creating an infrastructure or industrial

asset. For example, Roads is estimated to be close to 100

percent, while a thermal power plant is 20 percent.

The rest is towards equipment, mechanical fabrication,

electrical and non-construction engineering spend.

Defining

EPC Industry



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Route 1

Expanding scope from being engineering companies to

EPC companies. The most prominent example of this route

Engineers India Limited, which is Indias leading engineering

company, especially in the Hydrocarbons segment and now

offers EPC services. However, successful instances of this

route are limited.

Route 2

Expanding scope from being construction companies to

EPC companies. This is the more commonly followed route,

wherein companies have added engineering and procurement

capabilities to their existing expertise in mechanical and civil

construction. The leading example of this route has been

Larsen and Toubro, which moved from being a fabrication

and construction company in to one of the largest and most

respected EPC companies in India.

Route 3

Expanding scope from equipment supply to EPC companies.

This route has been more commonly followed in the engineering

and capital goods segment. Companies manufacturing major

pieces of equipment for a particular manufacturing process

have upgraded themselves to execute projects around their

equipments. Examples are Elecon, TRF who are suppliers of

material handling equipment and undertake projects in Power

Balance of Plant packages supplying entire Coal handling

systems or in industrial plants involving large material handling

components.

Route 4

A relatively new development has been of project developers

backward integrating and setting up their own EPC divisions.

This has been motivated by a desire to leverage their in-house

project management capabilities, and to capture the margins

typically belonging to contractors.

Setting

The CONTEXT



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Relevance of the EPC industry to the

India Growth Story

The 11th plan was an inflection point for the Indian infrastructure

story. The 11th plan laid the foundation for large scale

investments in infrastructure in India. Of the USD 500 billion

planned to be invested in the infrastructure, at the current rate,

it is expected that the plan will be met to 94 percent. This would

amount to 9 percent of Indias GDP and is expected to go up

to 10.25 percent of GDP.

Mid-Term Appraisal of 11th Five Year Plan

In order to achieve this plan, various pieces of the puzzle

need to come together, and would require all stakeholders,

the government, public sector undertakings, private sector to

contribute their achievements in a co-ordinated manner. It is

expected that the private sector would contribute 50 percent by

way of financing to achieve this plan. The obvious policy focus

has been on building financing capacity, formulation of PPP

policies in various sectors, policies around creating investment

clusters, land acquisition and environmental clearances.

However, the chain is only as strong as the weakest link.

Achieving this rate of infrastructure build-out calls for massive

capacity building down the chain in terms of manufacturing

capacities for equipments, raw material and commodity

capacities (e.g. steel, cement, fuels etc) and human resources.

Similarly, it calls for massive capacity building in the engineering

and construction sector in terms of reasonable number of large

to mid-size contracting or EPC companies available to be able

to undertake Lump-Sum-Turn-Key (LSTK) and sub-contracting

jobs in the country.

Purely from a construction perspective, investment in

construction is estimated to double to INR 16,809 billion over



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1 Source: Crisil Construction-Opinion August 2010

the next five years (2010-11-20114-15), from INR

8,895 billion recorded during the last five years1.

Within this the infrastructure segment, would

comprise 85 per cent of the total construction

investment. Within infrastructure segment, the

roads, power, irrigation and urban infrastructure

sectors would contribute around 73 percent of total

construction investment. The opportunity for EPC

players varies by industry given the contracting

models and construction intensity of each class of

infrastructure or industrial asset. CRISIL Resarch

estimates that investments in the industrial sector

would be 1.2 times in the next 5 years as compared

to the previous five years while in infrastructure it

would be 1.9 times, bringing the total growth to

be 1.7 times.

Projected Infrastructure Investments in 12th PlanBase Yr

(2011-12) 2012-13 2013-14 2014-15 2015-16 2016-17

GDP (USD Billion) 1,595 1,738 1,895 2,065 2,251 2,454

GDP Growth (%) 9.00% 9.00% 9.00% 9.00% 9.00% 9.00%

Infrastructure

Investment

(% of GDP) 9.00% 9.25% 9.50% 9.75% 10.00% 10.25%Infrastructure

Investment

(USD Billion) 144 161 180 201 225 252

Total Investments (USD Billion) 1,019

Source: Planning Commission



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2 TSR computation has been done for last 3 years data for companies which have been publicly listed in the last 3 years and may be classified as engineering and construction companies3 Source of data for analysis is Prowess, CMIE

Expectations from the EPC Industry

The EPC industry has gained prominent share of media,

investor and entrepreneurial attention in the last 3-5 years.

The stock markets have handsomely rewarded companies

operating in the infrastructure, construction and EPC space,

largely on account of future expectations. Similarly, the large

investment plans have raised expectations of customers from

this industry.

Investor Expectations

During the period of 2008-2010, the Total Shareholders Return2

(TSR) by the EPC companies has been ~31 percent. TSR for

the more broad-based Infrastructure index in the corresponding

period has been only ~ 9 percent. KPMG analysis indicates that

the expectations embedded in the current valuations indicate

that investors are expecting the leading EPC companies to grow

their order books and revenues at a rate of ~65 percent if they

continue to maintain current profitability and capital turnover

ratios, whereas the CAGR growth demonstrated in the last 3

years has been around 28 percent for the set of companies

considered below3.

Hence the stock market expectation of growth of EPC

companies appears to be very high. Private equity interest has

also been high in the industry.

RECENT EXAMPLES OF PRIVATE EQUITY DEALS CONCLUDED

CONSORTIUM OF PRIVATE EQUITY FIRMS, INCLUDING BARING, SEQUOIA CAPITAL, FIDELITY AND

DEUTSCHE BANK, ACQUIRED A 16 PERCENT STAKE IN INFRASTRUCTURE-EPC COMPANY COASTAL

PROJECTS FOR $54.8 MILLION1

AVIGO INVESTED $14 MILLION IN DELHI-BASED NAFTOGAZ INDIA PVT LTD, AN EPC PLAYER IN

THE O&G SECTOR.

DELHI-BASED UEM GROUP, SPECIALISING IN WATER & WASTE WATER COLLECTION, TREATMENT

AND DISPOSAL, MOPPED UP` 90 CRORE FROM INDIA VALUE FUND

CHENNAI-BASED AQUA DESIGNS INDIA, A WATER MANAGEMENT ENGINEERING COMPANY, RAISED

` 55 CRORE FROM PEEPUL CAPITAL

CONCORD ENVIRO SYSTEMS, A WATER MANAGEMENT ENGINEERING COMPANY, RAISED $10

MILLION FROM SAGE CAPITAL FUNDS IN DECEMBER 2009

A2Z MAINTENANCE & ENGINEERING SERVICES LTD (BACKED BY IEP, BEACON INDIA

PRIVATE EQUITY FUND AND MR RAKESH JHUNJHUNWALA), IS PRESENT IN POWER

DISTRIBUTION EPC BUSINESS.



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Total Shareholder Returns of Select Engineering and Construction

Companies

86.3%

74.5%

50.7%

38.9%

33.6%

32.3%

32.3%

31.5%

23.3%

23.2%

20.3%

17.1%

14.7%

14.1%

13.0%

12.4%

8.6%

8.5%

7.0%

4.5%

2.3%

3.7%

13.5%

20.0% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0%

Era Infra Engg. Ltd.

Engineers India Ltd.

Sadbhav Engineering Ltd.

Jaiprakash Associates Ltd.

Mcnally Bharat Engg. Co. Ltd.

Bharat Heavy Electricals Ltd.

Larsen & Toubro Ltd.

Ahluwalia Contracts (India) Ltd.

Gayatri Projects Ltd.

Thermax Ltd.

Hindustan Construction Co. Ltd.

Patel Engineering Ltd.

Alstom Projects India Ltd.

Madhucon Projects Ltd.

Punj Lloyd Ltd.

Unity Infraprojects Ltd.

Nagarjuna Construction Co. Ltd.

Ion Exchange (India) Ltd.

I V R C L Infrastructures & Projects Ltd.

J M C Projects (India) Ltd.

Gammon India Ltd.

S P M L Infra Ltd.

Elecon Engineering Co. Ltd.

Source: KPMG Analysis, financial data from Prowess, CMIE

In summary, the expectations from the investors are much higher

than the pace at which companies have delivered performance in the

recent past. This is an indicator of the strongly positive expectations

surrounding the sector, and hence the need for the industry to deliver

a consolidated performance in line with what is expected of them.



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The value proposition offered by the EPC industry is based

on the concept of risk sharing or risk transfer from the

project developer to the EPC

Company, at least to the tune

of the capital cost of the project

and to a limited extent to the

initial operating performance of

the plant / facility being built. In

exchange for that, the project

developers are willing to pay

a premium for the integration

services provided. Over a period

of time, customers have come

to expect a reduction in the total cost of putting up the plant

and the time schedule through the EPC route, compared

to exectution by the developer organization or the more

traditional route of procuring equipment, services and

engineering services separately

and owning the integration and

the project management.

It is important to point out

here that given the customer

expectations and the consequent

EPC business model, an EPC

company takes on a much higher

level of real and perceived risks

within a project, than other

service providers in the pure engineering, consulting or Project

Management space.

Customer Expectations

EPC company takes on amuch higher level of realand perceived risks withina project, than other service

p r o v i d er s i n t h e p u r eEngineering, Consulting orProject Management space.



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T h e p u r e

e n g i n e e r i n g ,

c ons u l t i ng o r

PMC serv ices

companies build

their business

models around

p r o f i t a b l e

c u s t o m e r

relationships, and

do not necessarily need profitability in each project that they

undertake.

However, the services of an EPC contractor are supposed

to be based on comprehensive contracts with little room for

interpretation and ambiguity, whereas pure engineering or

EPCM service providers do not take on most of the project cost

or time overrun risks which remain with the developer.

Given its business model, an EPC Company hence has to

target profitability from each contract, since the value at risk in

the case of overruns is very high, in proportion to its expected

margins. Further, the nature of the customer relationship

continues to be arms-length over the period of the contract,

as EPC companies look to protect themselves against time

and effort overruns delays on account of the developer and

a plethora of other risks that might take them off their initial

estimates. At the same time, customers want to ensure that they

get their plant or facility up and running, with the desired quality

in time and with no extra claims raised by the contractor.

APART FROM THIS BASIC CUSTOMER EXPECTATION, DURING OUR

DISCUSSIONS WITH PROJECT DEVELOPERS SEVERAL OTHER EXPECTATIONS

FROM EPC COMPANIES WERE COMMONLY MENTIONED

EPC COMPANIES NEED TO IMPROVE THEIR FINANCIAL AND BALANCE SHEET STRENGTH TO BE

ABLE TO TAKE ON LARGER JOBS, AND NOT DEPEND ON ADVANCES AND FAST TRACK PAYMENTS

FROM DEVELOPERS TO BE ABLE TO PROGRESS

INDIAN EPC COMPANIES NEED TO SIGNIFICANTLY IMPROVE THEIR ENGINEERING CAPABILITIES,

ESPECIALLY ON THE FRONT END SIDE. THIS IS ESPECIALLY TRUE FOR THE ENGINEERING

COMPANIES WHICH ARE RESPONSIBLE FOR PREPARING THE FEED (FRONT END ENGINEERING

DESIGN) PACKAGE SO THAT LSTK BIDDING CAN BE FACILITATED.

DEPLOY LATEST CONSTRUCTION METHODOLOGIES AND TECHNIQUES, BOTH MANAGERIAL AS

WELL AS TECHNICAL TO EXECUTE PROJECTS FASTER AND TO BETTER QUALITY.

DEVELOP EMPOWERED PROJECT MANAGERS, SO THAT THEY CAN ACT AS MORE THAN JUST

COORDINATORS, AND CAN INTERFACE WITH THE SENIOR MOST LEVELS IN THE CLIENT

HIERARCHY AND TAKE DECISIONS TO RESOLVE PROJECT ISSUES.

The EPCgame iscompetitive,

while

EPCMgameis about

relationship&trust



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Value Creation Strategies

The project level value creation driver in terms of profitability

for an EPC company is its ability to

a) Correctly estimate the detailed costs and time schedules

of a project and

b) Manage the entire ecosystem of customers, vendors,

regulators, engineers and sub-contractors, to deliver within

those estimates.

Sources of Long Term Value CreationHowever, long term value creation requires EPC companies

to improve in all three aspects that impact the market value

of a company performance, prospects, and financing. While

performance is enhanced both through revenue and profit

growth, future prospects are enhanced when the EPC company

is positioned well to serve high growth segments and profitable

customers. Financing component of value creation involves a

reduction in the risk premium and discount rate associated with

future cash flows of the company. This can be achieved by a

combination of a reduction in actual cost of borrowing and the

expected cost of equity through improved risk management

practices and reduced volatility of revenue streams.



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Scale and other Value Drivers for EPC companies

Performance improves for an EPC company with scale, as

it is able to leverage efficiencies in procurement, overheads,

relationship building with vendors and sub-contractors. Also,

there are scale opportunities created when companies are able

to invest in standardization of designs, value engineering and

investment in world-class tools and techniques.

The other two important aspects for value creation are Growth

to create future prospects and Risk Management which are

covered subsequently.



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Diversification is a key element of

growth, and will be aggressively

pursued in India. It is driven

not only from the point of growth, but

also from the perspective of managing

volatility in order booking. Presently, the

established EPC companies operating

in a limited set of industries in India,

are also perceiving a high risk to their

order booking levels due to the large

number of new entrants into the EPC

space, as well as a perceived dilution

in qualification criteria from many

customers that appears to be providing

a level playing field to the new entrants.

Hence diversification has become a

popular mode of seeking both growth

and stability in revenue streams of EPC

companies.

Route 1

HORIZONTAL EXPANSION Existing

EPC companies are diversifying in to

new end-use industry sectors, inspired

by the large investments coming up in

these sectors. For example, Punj Lloyd,

a player in the Oil and Gas space,

expanded in to the Power Generation

EPC market and has recently won orders

in the Balance of Plant EPC space.

Similarly, Tata Projects has entered in to

a JV with EIL to form a TEIL, to address

the investments in the Oil and Gas space.

The JV leverages EILs engineering

know-how, client relationships in the Oil

and Gas sector and the LSTK contract

execution capabilities of Tata Projects.

There are many other examples, of such

strategies being followed by companies

all over the country.

Route 2

VER TI C A L EXPA N SI O N Some

companies are expanding to control

more of the investment value of the

project, by becoming system integrators.

A large proportion of these companies

are equipment vendors, who believe that

they have the ability to execute contracts

on a turnkey basis. Examples of this route

being followed being prevalent largely

in the Power Generation equipment

side. For example companies like

Elecon, TRF which were earlier primarily

material handling equipment vendors

are now competing for turnkey

material handling systems

packages. Similarly, there are

engineering companies like

EIL, who are now offering EPC/

LSTK services to their clients.

The vertical expansions have

been driven by the desire to

enhance the top line and to

control a larger share of the

investment pie. Engineering

services contribute not more

than 5-10 percent of the total

plant investments, and while

engineering services have

higher margins and relatively

lower risks, it doesnt provide aggressive

top line growth. Such vertical expansion

into Construction and Project Execution

by publicly listed manufacturing or

engineering companies, is also driven

by the higher earnings multiples currently

associated with such high potential

businesses. The market recognizes that

construction and project management

service providers will be in short supply

and high demand in the short to medium

term.

As a note of caution, however, it is worth

mentioning that companies who enter

the Projects business from product

manufacturing or engineering services

backgrounds, need to carefully built

the required capabilities for project

Routes to Growth

DIVERSIFICATION

PROMISES GROWTH

& STABILITY IN

REVENUE STREAMS

EXPANSION MODES

Horizontal

Vertical

Backward Integration



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execution, and identify and manage their

risk exposure in a higher risk business in

a calibrated manner. Several traditional

manufacturing companies have faced

financial difficulties in managing their

project businesses in the recent past.

Route 3

BACKWARD INTEGRATION Many

Indian entrepreneurs have typically

wanted to control as much of the value

chain as possible. The story is being now

repeated in the EPC industry - Reliance

ADAG has Reliance Infrastructure,

while Essar Group has Essar Projects.

GMR has its own EPC division, while

the Tata Group has Tata Projects. Many

other business houses have established

strong internal project execution teams.

Moreover they believe they can derive

substantial benefits on procurement

activities through in-house procurement.

Further, as an executive from one of the

leading players in the industry pointed out

large business houses making significant

investments believe that there isnt

enough expertise and scale within the

existing EPC companies for assuming

and managing their project risks.

In the Power Sector, for example, the

only large full service EPC company that

comes to mind is Larsen and Toubro,

which can offer full EPC, BTG package,

BoP package and also individual

equipments and sub-systems. There

are few others capable of simultaneously

executing a number of full EPC projects in

the Power Sector. One private developer

mentioned that the available set of EPC

companies does not inspire confidence

in their being able to deliver projects on

time and with the initial estimated cost.

Typically in such scenarios, the risk of

both schedule and cost is transferred

back to the developer in forms of claims

and counter claims on who is responsible

for delays and escalations. As a result,

the developer feels compelled to manage

his projects on his own if he has the

organization and resources to do so,

and a large enough pipeline of projects

to utilize these in-house resources

efficiently.

International expansion for growth

has really not been a focus area for

most Indian EPC companies given the

growth in the domestic sector, and the

stiff competition posed internationally

by the global majors. However,

there remain certain sectors where

international expansion is likely. The

Indian Oil and Gas plant engineering

and construction market has all the

global majors present in India. Hence,

Indian companies competing with

them have raised their game to the

international level in this field. Hence

companies like Larsen and Toubro,

Punj Lloyd, Essar Projects have won

business at the international level

and should continue to do well in the

hydrocarbons space. Similarly, sub-

contractors in this space (e.g. Petron

Engineering) may also be able to

compete internationally, as they have

been working as sub-contractors to

global companies in India.

On the other hand, there are niche

International ExpansionCOMPANIES WHO ENTER

THE PROJECTS BUSINESS

FROM PRODUCT

MANUFACTURING OR

ENGINEERING SERVICES

BACKGROUNDS, NEED TO

CAREFULLY BUILD THE

REQUIRED CAPABILITIES

FOR PROJECT EXECUTION,

AND IDENTIFY AND

MANAGE THEIR RISK

EXPOSURE IN A HIGHER

RISK BUSINESS IN A

CALIBRATED MANNER.



22/54


EPC segments, with limited market size

in India, which has prompted Indian

companies in these domains to go

global. Examples of this are to be found

in Walchandnagar for sugar and biomass

based power plants, KEC International

for EPC in transmission and distribution

space. Some of these expansions have

been facilitated by global acquisitions

as well for example the acquisition

of the mineral beneficiation equipment

business of cement major KHD Humboldt

Wedag by McNally Bharat Engineering

has provided them a foothold in the

international market. Similarly, the

acquisition of Sembawang and its

subsidiary Simon Carves has significantly

improved the international profile of the

Punj Lloyd. KEC International acquired

SAE Towers business, a leading

manufacturer of steel lattice structures

for transmission towers with subsidiaries

in Brazil, Mexico and US. This is the most

plausible route that Indian companies

are likely to take acquiring companies

in niche areas globally to create large

multi-country EPC businesses. There

are no large acquisitions of note in the

main plant EPC market, other than Punj

Lloyds acquisition of Sembawang.

In the domestic market, diversification

in to newer areas by EPC companies

has been accompanied by acquisitions

or JVs - particularly in the Hydrocarbons

space, wherein the qualification criterion

are quite stringent for entry.

Tata Projects acqui red Artson

Engineering, while entering into a JV

with EIL for its Oil and Gas foray. IVRCL

acquired Hindustan Dorr-Oliver to

strengthen its Water Treatment business

and gain a foothold in the mineral

beneficiation plant construction market.

We expect the acquisitive activities

of Indian EPC companies to intensify

over the next 3-5 years. Opportunities

for partnering or acquisition will arise

as smaller, niche EPC companies find

it difficult to compete against large

companies. Additionally, the recent bout

of aggressive bidding by Indian EPC

companies is likely to throw up winners

and losers in the next 3 to 5 years. This

will likely lead to consolidation in the

industry.

GLOBAL ACQUISITIONS

BY INDIAN COMPANIES

Mineral beneficiation

equipment business

of cement major KHD

Humboldt Wedag

by McNally Bharat

Engineering

Sembawang and itssubsidiary Simon Carves

by Punj Lloyd

SAE Towers business,

a leading manufacturer

of steel lattice structures

for transmission towers

with subsidiaries in Brazil,

Mexico and US by KEC

International



23/54


Contracting Models

Model Role of EPC company Drivers / Highlights

EngineeringProcurementand ConstructionManagement(EPCM)

System engineering, optionallydetailed engineeringDetailed cost estimationP a c k a g e a n d s u b - c o n t r a c tstructuringManaging bid / vendor selectionprocessQuality management ( includingdrawing approvals of vendors, sub-contractors)Supervision of construction, erection,commissioning, performance testingProject Management ( sometimesan additional Project Managementagency)

Commonly practiced in process industryPlayers like Engineers India Limited, Uhde, FosterWheeler, Technip, Technimont ICB etcContract values are small as compared to LSTK,however high marginMinimal risk for EPCM companies, however customersnow insist on incentives based on project cost andschedule as compared to original estimatesPlaces responsibility of managing risks, cost controland procurement on the project developerPreferred in the Indian context due to in-housecapabilities of Indian entrepreneurs and willingnessto take risks, and save margins

EPC - Lump Sum

Turn Key (LSTK)

E n g i n e e r i n g , p r o c u r e m e n t ,

construction, commissioningThe extent of information providedvaries, typically all the drawings anddesigns are provided to constructioncompanies to bid, while in some casesonly the conceptual design may beprovided

Complete risk transfer to EPC company

Very large contract sizes, equal to the projectinvestmentHigher adoption in India of this model in the infrastructuresegments ( Roads, Water, Hydro Power etc)Limited adoption in the industrial segment

Package EPC E n g i n e e r i n g , p ro c u r e m e n t ,construction and commissioning of aparticular unitMost likely to involve mechanical,electrical, instrumentation, utilities civiland structural scope

Project developer splits the project in system or unitpackagesMost commonly used method in Process plants, powerplants especially by the public sector. E.g. NTPCbreaks the Power plant in to packages like BTG, CoalHandling, Ash Handling, Water Treatment etcContract sizes can be as large as INR 2000 Crores

Contracting Models and their Drivers

The demand for the EPC industry is driven by the contracting models adopted by customers. Theoretically, the EPC industry is

driven by the need to reduce the risk for the developer, at the same time leveraging the expertise of the EPC player to reduce

the overall execution period and cost. Some of the prevalent contracting models are mentioned below:

Source: KPMG Research and Analysis, Industry inputs

Key External Drivers and Issues



24/54


The choice of the contracting models are

driven by multiple factors

Internal capabilities of the project

developer

Influence of financial institutions

Availabil ity of enough number of

quality LSTK suppliers

Prevai l ing market condit ions,

including supplier power. In a capacity

constrained scenario, contracting

models move towards shifting the

risks on to the project developers.

However, a few general trends can be

drawn based on the above drivers, as

follows:

In the infrastructure segments, the

contracting models are moving

towards transferring more risk to

contractors, including operating risks

in the form of BOT, BOOT models.

In the industrial segment, it is

expected that the EPCM or even

lesser risk models will continue to

dominate.

What wi l l t i l t the balance in

favour of turnkey models in the

industrial segment is the entry

of new developers, especially

in the mid-scale segments, who

have limited internal capabilities to

execute projects without LTSK type

contracts.

Order Book Uncertainty

One significant trend in industry,

especially where projects are being

awarded through the competitive bidding

in the public sector, is the emergence

of a large number of relatively small,

unknown players bagging significantly

large contracts.

While it is important from a capacity

building and competitive stand point,

it has led to order book uncertainty for

the incumbents. At the risk of sounding

anti-competition, a senior management

executive of a large EPC company

suggested that it is not a healthy trend

at all. It is leading to contracts being

bagged by companies with limited

capabilities, which will affect projects

in the medium to long run. While the

extent of truth in this prophecy can only

be borne out over time, it is a fact that this

phenomenon has increased the order

book uncertainty for the incumbents.

Strategic planning methods based

on projected capital expenditure and

historical market shares do not throw up

reliable revenue projections, and there is

scramble to hedge risks by diversifying

and being present in as many sectors as

possible. There are numerous examples

around this; a look at the portfolio of the

top 10 construction companies in India

illustrates this point.

Another ramification of this order book

uncertainty is the appetite for investment

in manufacturing or in-house value

addition. The BTG manufacturing

capacities of private sector companies

in India like that of L&T, Bharat Forge,

Thermax, BGR etc are faced with the

prospects of being under utilized as

most main plant equipment orders have

been won by BHEL and the Chinese

companies.

This phenomenon was also seen in the

Roads sector, where there is consequently

now a cap on how many orders can be

placed on a single company, and also in

the Balance of Plants in Power space,

where multiple companies have sprung

up to take advantage of the under-

capacity scenario.

CONTRACTSbeing bagged by

COMPANIESwith LIMITED

CAPABILITIESwill affectPROJECTSinthe medium to long run



25/54


4 NSDC report on Human Resource and Skill Requirements in Building, Construction Industry and Real Estate Services

Human Resources

The shortage of skilled manpower is

most acutely being felt in the construction

industry. The construction industry

currently employs 32 million people in

the country. It is estimated that 1 percent

increase in GDP translates to 1 percent

increase in jobs for the construction

industry. With the accelerated investment

in infrastructure, this is only going to

increase. If the 12th plan envisages

doubling of infrastructure investment

from the 11th plan, it calls for doubling

of requirement for the construction

industry, which indicates a large shortage

of resources. While mobilization of

unskilled labour at construction sites

may be of relatively lesser concern, the

need for doubling the skilled resources

available in the country is being acutely

felt. Anecdotal evidences indicate that

construction managers with 15+ years

of experience in building high quality

roads are now drawing compensation

in the same range as their peers in

advanced countries, which was unheard

of in the Indian context. Industry leaders

are worried about the shortage of skilled

workers like carpenters, fitters, welders,

but what they lament the most is the

lack of Project Managers with adequate

experience and skill levels to execute

the ever increasing size and complexity

of projects.

The 11th plan envisages the development

of a National plan for Human Resource

development through training and

certification of construction personnel.

However, industry participants feels

that this large capacity building will

require significant private sector effort,

for establishing training institutes, setting

course material and reducing trainee

career risks by providing absorption.

While the need for upgrading the current

set of ITIs and vocational training institutes

is felt, more importantly, there is a need

to establish training centers with private

participation at major labour centers in

the country, in the semi-urban and rural

areasThe challenge is accentuated due

to the demand centers and the supply

centers being different. The supply

is likely to be driven predominantly

by states like Orissa, West Bengal

and Bihar, especially at the minimally

skilled levels4. Centum Learning, a joint

venture between Bharti Groups Centum

Learning and NSDC is one initiative,

to skill and train 1.2 crore Indians on

workskills in sectors like Telecom, Retail,

Building and Construction. However,

there is need for many more, especially

from the Construction Industry itself.

Hence there is an urgent imperative for

collaborative action by the Engineering

and Construction companies in investing

in skill building at the supply centers, in

a non-competitive environment. In the

meantime, the government may have

to refrain from disallowing the use of

foreign labour for project

execution, till such time as

skilled labour shortages are

addressed.

While, the skilled resource

The existing public school infrastructure can beupgraded through private participation with minimaladditional expenditure with after-school hours used forproviding vocational skills- Senior Executive at an EPC company

Incremental Human Resource Requirement(including skilled workforce) in 000s

Profile of People IncrementalRequirement

Project Managers andEngineers

473

Supervisors 473

Foremen 946

Crane Operators 7

Electricians 473

Weleder 473

Source: National Ski l l DevelopmentCorporation and IMaCs study on HumanResource skill gaps in Building, Constructionand Real Estate



26/54


requirement at the Engineer and

Supervisor levels is a constraint as well,

we feel that it is easier addressed as over

a period of time through private sector

participation in engineering education,

as this is financially rewarding even

with limited or no government support.

What may be needed though is more

specialized curriculum development

(for example Power Plant engineering).

A second requi remen t is for cross-

functional engineering ski l ls and

exposure. The EPC industry needs a set

of professionals to act as integrators, who

can act as engineering coordinators and

are comfortable with various engineering

disciplines and not just one specific

discipline. It is only with the availability

of such talent, that companies can

innovate, carry out value engineering

to improve the overall productivity of a

capital project.

The second of critical challenges apart

from technical and skilled labor, lies in

developing managerial talent. There

are few institutes focusing on teaching

Project Management, especially for

the construction industry in the country.

In the absence of specialist finishing

schools for Project Management, the

industry relies on in-house training, and

on-the-job training programs. While

those are important, there is a need to go

beyond the generic project management

credits introduced in business schools

or engineering institutions. It is strongly

believed that the development mandate

given to the Construction Industry

Development Council and the National

Institute of Construction Management

and Research (NICMAR) needs to be

supplemented by the establishment

of some such high quality Project

Management schools.

There is a need for building a high profile projectmanagement school along the lines of an IIT/IIM, all we need is some land allocation and theindustry can do the rest

Senior Executive of an EPC company



27/54


5 http://www.doingbusiness.org/rankings

Ease of Doing Business Ranking for India

(i) Ease of doing business in India

In the latest rankings5for ease of doing business, India is ranked 134th in the world.

Contracts

Ease of

Doing

Business

Starting a

business

Dealing with

construction

permits

Registering

property

Getting

Credit

Protecting

investors

Paying

taxes

Trading

across

borders

Enforcing

contracts

Closing a

business

134 165 177 94 32 44 164 100 182 134

Source: World Bank Group, Ease of Doing Business Rankings, 2011

Managing within a weakly enforced regulatoryframework is a competitive advantage for Indiancompanies- Senior Executive at an EPC company

India scores particularly poorly in the

establishment of new business and

construction, closure of businesses,

and enforcement of contracts. While,

one may argue that these rankings

mean little to investors and companies

who see the immense potential of India,

as also reflected in the FDI flowing

in to the country. However, for many

global companies contemplating entry

into India, these are not encouraging

indicators. One of the worlds leading

design engineering and consultancy

firms, while evolving it strategy for

emerging markets recently, found these

rankings to be particularly forbidding in

its evaluation of Indias attractiveness as

a business location.

Risk Assessment ofTypical Contracts

During a recent engagement for an Indian

EPC client, we studied the risk evaluation

frameworks in use by international

majors. We found that many international

companies would rate typical Indian

projects as No-Go. While the reasons

would typically also include issues

related to logistics constraints and overly

aggressive delivery periods, the primary

reason for such evaluations, we found,

were the typical contractual clauses,

including payment and retention terms

which detract international companies

from taking up large contracts in India.

Moreover, many EPC companies find

arbitration as a lengthy process in India,

and hence the risk averse companies

assume that in case of any disputes,

they will have to accept terms from

the customer. Interestingly, as a senior

executive in in an EPC firm told us,

the ability to manage within a weakly

enforced regulatory framework is a

competitive advantage for Indian EPC

companies who have learnt to operate

under these conditions. For example,

these companies have realized that

Liquidated Damages are rarely enforced

by Public Sector clients. Further,

new infrastructure developers, when

dealing with large experienced EPC

firms operating in India, find it difficult

to prevent extra claims, and costs

from escalating.



28/54


We feel, the industry requires that nodal

agencies in various government sectors,

take up these issues, to align the project

contractual clauses to international

standards, particularly if they wish to

receive enough number of bids in the

International Competitive Bidding routes,

reduce the number of disputes and raise

the trust levels in the industry between

project developers and engineering and

construction companies.

Taxation

Direct tax

A typical EPC contract will have the

following scope of work in a single

project:

Supply of equipment (offshore and

onshore);

Installation / commissioning

Services (offshore and onshore)

Software / Technology transfer

(offshore and onshore)

Under a typical EPC contract, a non-

resident contractor performs multitude

of activities. The scope of work under

EPC contract:

Offshore:Offshore supplies and

offshore services

On-shore: Onshore supplies and

onshore services (installation,

commissioning, etc.)

Taxability of payments received by

foreign companies in respect of EPC

contracts, especially in respect of off-

shore supply of goods / services under

a composite contract, has become a

matter of great debate and litigation.

Equally important is the issue in relation

to withholding tax on such payments.

The onshore supplies and services are

normally taxable in India.

There has been a lot of litigation in

relation to taxability of offshore supply

and offshore services. However, the

controversy in relation to offshore

services is now rested with an amendment

in the domestic law and accordingly

offshore services are now taxable in

India if they are uti lised in India. A general

principle which was emerged out of the

judic ial precedents is that profit from

offshore supplies would not be taxable

in India provided following conditions

are satisfied:

Principal to principal transaction

Title (i.e. risk and ownership) in the

offshore supplies passed to the buyer

outside India

Sale consideration is received

outside India

Sale is at arms length

Although the above rulings suggest that

offshore supply may not to be taxed in

India, the taxability depends of facts

of each case. Further, the revenue

authorities have not accepted the above

rulings and hence, it is still a matter of

controversy and litigation. Hence, it

is advisable to structure contracts in a

tax-efficient manner after taking into

account the peculiar facts of each case.

Further, there as several provisions

under the Proposed Direct Taxes Code,

2010 such as General Anti Avoidance

Rules, etc. that will have to be taken into

consideration while entering into EPC

contracts.

Permanent Establishment (PE)

Issues

Deputation of personnel for erection /

installation / commissioning / designing

/ tr ai ni ng ac ti vi ti es is a co mm on

phenomenon in case of EPC contracts.

The ambit of the domestic law of India is

very wide and it tries to tax income from

all the activities which give rise to some

business connection in India. Based

on the tax treaty, the business income

of foreign companies would be subject

to tax in India only if they have a PE in

India. There are various types of PEs like

fixed base PE, agency PE, service PE or

construction / installation PE.

Practically, in an EPC Contracts, activities

take a long duration to complete, and

hence PE clause (especially fixed base,

construction / installation PE and service

PE) comes into play in this industry more

often. This would imply that a foreign

company rendering services in India for

more than the specified period would



29/54


be taxed in India in addition to being

taxed in the country of residence only

by virtue of the fact that services are

being rendered in India for more than

the specified number of days or they

have a virtual presence in India. Hence,

it is important for the EPC contractor to

structure their operations and contracts

to mitigate PE exposure.

Association of Persons (AOP)

Generally, two or more EPC contractors

come together to bid for EPC contracts

in the form of a consortium. In such

a situation, an AOP exposure would

arise. The term AOP is not specifically

defined in the Act. One has to rely on the

ordinary meaning and the law emerging

out of the judicial decisions to determine

what constitutes an AOP. Whether

AOP exist or not is a very vexed issue

and much depends upon the facts and

circumstances of each case.

Following are the consequences of

constituting an AOP:

Applicability of Maximum Marginal

Rate;

Issues in relation to carry forward

of losses;

Issues in relation to Foreign Tax

Credit;

Taxation at two level due to

applicability of Minimum Alternate

Tax on profit distribution from AOP

BROAD PARAMETERS TO

ANALYZE CONSTITUTION OF

AOP

TWO OR MORE PERSONS

VOLUNTARY COMBINATIONS

A COMMON PURPOSE OR COMMON

ACTION WITH OBJECT TO PRODUCE

PROFITS OR GAINS

SHARING OF PROFITS AND

LOSSES

JOINT AND SEVERAL LIABILITY OF

THE MEMBERS; AND

SOME KIND OF SCHEME FOR

COMMON MANAGEMENT



30/54


Key Internal Issues

The key internal challenge facing the

Indian EPC industry today is issue of

being able to manage scale and diversity,

with the rapid growth in business and

diversification into new business areas.

Other issues around improving the

quality and value addition of engineering,

implementing leading practices in

project management, implementing

modern construction methods are

also specific challenges facing the

industry players, but we believe these

will get addressed in natural course

as the EPC industry matures in India.

However, the core challenge facing the

mid-size, fast growing companies are

around effective project management,

management of growth and scalability

without compromising on project and

business risks, and developing systems

and processes to make companies

more scalable and less dependent on

individuals.

Project Management

E+P+C is not equal to EPC said

the director of one of Indias leading

engineering and construction company.

The glue that binds all these together

is Project Management. Project

Management is a science, with its own

school of tools and techniques, both

in the scientific and the behavioural

domain.

In our company, project managers

are GODs is the common refrain

in international EPC or engineering

companies. However, this is not the

case in Indian EPC companies, as

is evident from various perspectives

provided by Indian companies as well

as developers. A leading Hydrocarbon

major, in an industry forum, called upon

the EPC companies in India to develop

better project management talent, and

especially requested the Indian offices

of global firms to rotate local talent

through global assignments to develop

these skills.

Most mid-size fast growing EPC

companies in India are facing issues

related to empowerment of Project

Managers and the primacy of the Project

Management function in an EPC firm.

As a result, projects are de facto mana-

ged by Business Unit Heads or other

very senior professionals,

reducing the designated

project managers to co-

ordination roles, and resulting in senior

management being involved in day to

day project issues.

Further, with business growth, senior

executive time available for a specific

project becomes limited, resulting in

loss of execution control. We suggest

that fast growing mid-size companies

relook at their organization structures

and policies to ensure that their project

managers are empowered. They should

have accountability for project cost and

time control, and adequate control over

decisions related to the project.

E+P+C is not equal to EPC

RESPECT FOR SENIORITY IN INDIA LEADING TO PROJECT MANAGER

EMPOWERMENT ISSUES

THE OTHER DIMENSION OF THE CHALLENGE IS THE RESPECT FOR SENIORITY IN THE INDIANCULTURE. WHILE PROJECT MANAGERS ARE DE-FACTO CEOS OF A PROJECT, THEY MAY NOT ALWAYS

BE MOST SENIOR IN THE PROJECT ORGANIZATIONS HIERARCHY. THE PROJECT TEAM MAY CONSIST

OF ENGINEERING COORDINATORS, CONSTRUCTION MANAGERS WITH MANY MORE YEARS OF

EXPERIENCE WHO WOULD BAULK AT REPORTING TO THE DESIGNATED PROJECT MANAGER DUE

TO THEIR CULTURAL CONDITIONING.



31/54


Organization Design & Management:Building the Engineering

ORGANIZATIONAs we discussed earlier in evolution of

EPC companies, most EPC companies

are likely to evolve from the construction

or the developer route. In both the cases,

the key capability gaps would remain in

the domain of engineering. While Project

Management is the execution arm,

engineering does and should function as

the brain, adding competitive advantage

in terms of standardization, value

engineering and technology leadership.

Engineering which being a knowledge

based function requires careful design of

organization structures, career paths and

development strategies, and a different

approach to performance assessment

and management as compared to the

other functions in the organization.

Als o, wit h rapid divers if ica tion, the

centralization vs. decentralization

question stares at managements of

EPC companies, who would like to

balance efficiency with effectiveness.

For example, companies tend to

cent ra l i ze end-use / p rocess

independent engineering disciplines

like civil, structural and electrical, while

the other disciplines are de-centralized.

However, there is no right answer, it

needs to be carefully assessed in light

of the companys portfolio, strategy and

culture.

Source: PMI-KPMG Study on drivers for success in infrastructure projects 2010 - Managing for change

Risk ManagementLess than one third of the survey respondents in KPMG-PMI Infrastructure report,

had confidence in their risk management capabilities.

The EPC business model revolves

around taking ownership of project

risks. Hence it is absolutely critical for

EPC companies to establish robust

processes for risk identification and risk

management. Such a process would

address risks identifiedat both the sales and

execution stages of the

project.

While the ideal situation

w o u l d b e f o r E P C

companies to be able to

identify, mitigate or provide

for all risks at the tendering

stage, this is usually notpractical, given the need

to complete bids within

a specified deadline, and

to not rely indiscriminately

on additional contingency

margins that may impair



32/54


Source: PMI-KPMG Study on drivers for success in infrastructure projects 2010

- Managing for change

The KPMG-PMI study in 2010 also

highlighted the some concerns on the

comprehensiveness of risk identification

by companies, given the high incidence

of projects having suffered due to risks

that were hitherto unidentified and hence

not mitigated. Critical improvements are

also required to acquire a robust level

of sophistication and maturity in risk

mitigation. Routinely used mitigation

the competitiveness of the bids. Hence

while key risks are identified and mitigated

during the bidding stage, a large number

of additional or minor unmitigated risks

may need to be addressed during

ongoing project execution. Most leading

international EPC companies, process

all enquiries / tenders through a risk

identification process based on which,

go-No-go decisions are taken, and risk

ratings are assigned to each project or

proposal.

The more sophisticated systems also

have contingencies and margin policies

based on risk ratings. Similarly, the

portfolio of projects is weighted based

on risk categories as strategic planning

inputs. Another common element is

Independent review of risks by personnel

not directly involved in Project Sales or

Execution. With the rapid growth in

order books, and a senior management

stretched for time, it is essential that

Indian companies also rely less on

individual or subjective experience

and expertise, and more on agreed

risk management tools and objective

frameworks which can be used even

by less experienced people with the

help of knowledge and experience that

is codified into these tools. These risk

assessment frameworks, customized

and developed with the inputs from

senior management of the company, can

flag off critical risks in the tenders, and

ensure awareness and more informed

decision making during bidding. Also,

nuanced and differentiated processes of

project execution, monitoring and control

and staffing of projects based on the risk

assessment will help in focusing the

best and most careful decision making

capacity towards the most risky of the

projects in a companys portfolio.

strategies are either reduce, transfer or

avoid. While accept risk type strategies

are used infrequently, exploit strategies

are rarely used. The industry thus isyet to reach maturity levels at which

mitigation strategies are leveraged to

exploit project risks and are used as

means to maximize project income

potential.

Risk reporting and monitoring are the

remaining links in the risk management

process that are cr i t ical for i ts

effectiveness. Evolving informationsystems can make timely and accurate

project information for reporting

purposes. The information reported

should comprise early warning indicators

and provide content that facilitates

decision making.



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Procurement

Procurement can be a vital element

influencing timely and profitable project

delivery in EPC projects. In projects with

low construction intensity like Power

projects, Refining and Petrochemical

complexes and other industrial plants, just

the standard bought-out components

may comprise anywhere between 30-50

percent of the project value, apart from

other procured items like construction

materials and sub-contracted services.

There are several reasons leading to

complexity in the procurement function

of an EPC company:

Number of individual items to

be procured for a large project,

within specific and often varying

deadlines.

Cost targets for Procurement are

usually set at individual component

level, not at an overall Procurement

budget level s ince senior

management usually does not

disclose overall project cost budgets

for confidentiality and flexibility

purpose.

The constant trade-offs between

procurement time and procurement

costs to meet the often conflicting

goals of cost control vis-a-vis

schedule control on a project.

It requires companies to evolve strong

sourcing teams, capable of vendor

discovery and price discovery on a

larger scale than would be required

in a manufacturing set-up. In most

manufacturing companies, rate contracts,

differentiated procurement processes for

minor vs. major items, and MRP based

procurement processes reduce the

transactional overhead significantly.

Moreover, most public sector units have

made, depending on how one looks

at it, the job easier or more difficult for

contracting companies by providing

vendor lists. This has resulted in vendor

development take a backseat as the

burden of that job has been transferred

to developer or the consultant.

This is however, not the case with private

sector clients, especially new entrants.

EPC companies we believe, would

benefit significantly from an increased

focus on vendor development, including

supporting high quality emerging vendors

in getting themselves accredited with

PSUs.

Given this context, we feel Procurement

capability can emerge as a strategic

differentiator for improving performance

and winning business in the EPC

industry. It requires efforts on the part

of engineering, procurement and client

facing personnel to discover, qualify

new suppliers and convince customers

to include them in their approved lists or

allow deviations on the projects. We feel

however, in the emerging high growth

but hyper competitive scenario for EPC

companies, this would be a worthwhile

investment to make.

EFFICIENCY IMPROVEMENT INITIATIVES FOR PROCUREMENT

FUNCTION

REDUCE CYCLE TIME, BY DESIGNING THEIR PROCUREMENT PROCESSES FOR INCREASINGDECISION MAKING SPEED

REDUCING THE NUMBER OF TRANSACTIONS BY STANDARDIZATION AND IDENTIFYING COMMON

ITEMS ACROSS PROJECTS EXECUTED IN THE PAST

IMPROVE THE COMPETITIVENESS OF THEIR SUPPLIER BASE BY CASTING THEIR NET WIDER,

INCLUDING ELEMENTS OF GLOBAL SOURCING IN THEIR STRATEGY



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6 And not necessarily poor planning

End-Use Industry Views

Power Generation Units especially

thermal power plants are likely to be

amongst the largest opportunities for

EPC players in the short to medium

term. The thermal power and nuclear

power units both have relatively lower

civil construction component and

require superior capabilities in terms of

equipment sourcing, engineering and

integration management as compared to

other infrastructure classes like Roads,

Ports etc.

Demand Outlook

By 2015, India would need to increase

its current generation capacity of 152

GW to 205 GW (an increase of 53 GW)

till year 2014-15 for meeting the baseload capacity requirement to support

growth of economy at 8 percent and

address unavailability of power in many

parts of the country. To meet the peak

load capacity requirement, the installed

capacity requirement would need to be

more than 270 GW.

The generat ion capaci ty gap to

meet baseload requirements varies

significantly across regions and is

estimated as 62 GW in Western Region,

62 GW in Northern Region, 54 in the

Southern Region, 24 GW in the EasternRegion and 3 GW in the North Eastern

Region of India in the year 2014-15. This

projection implies an average annual

generation capacity addition at the rate

of 16 GW per year during the period

2007-08 to 2016-17 (covering two 5

Year Plan periods in India viz. XIth and

XIIth). During the IXth (1997-2002) and

Xth (2002-2007) 5 Year Plan periods,

the average annual generation capacityadd i t i on in the

country has been

3.6 GW and 4.2 GW

respectively. The

poor performance in

the past is attributed

to implementation

d e l a y s 6 by the

public sector utilities

coupled with hithertolimited private sector

participation.

A bottom up analysis

of expected plant

additions was conducted based on a

variety of sources such as the CEA

database for upcoming additions,

industry reports and KPMGs internalassessment. Only those plants which

have reached an appropriate state

of readiness for commencement of

commercial operations within the period

FY 2010-15 have been considered

for capacity addition. Effective supply

addition for each year of the period

(FY 2010-15) was calculated based on

the total capacity addition. We expect

a total capacity addition of 99 GW inthis period. Assuming a similar rate,

this translates in to an approximate

opportunity size of INR 500,000 crore

(i.e. over USD 100 Billion) towards

capital expenditure for these plants.

The majority of this investment will be

towards thermal power plants, of which

80 GW are likely to be commissioned by

2015. The opportunities for EPC players,

equipment vendors are for projects whichare likely to get commissioned beyond

2012-13 as they are the ones which are

mostly likely yet to be tendered out - for

balance of plant equipment if not main

plant equipment.Source: KPMG Research and Analysis

Expected Capacity Addition (GW)

Power Generation



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7 Source: http://www.sify.com/finance/ntpc-likely-to-float-rs-18-000-cr-tender-news-equity-km4bvDidjib.html

End-Use Industry Specific Issues

The thermal power industry has been

one of the fastest to adopt the EPC

model

The Power Generation industry has

seen one of the fastest adoption rates

in terms of EPC contracting model.

Prior to the reforms in the power sector

and the policies around public private

partnership models, power plants were

being constructed by the state level

generation companies and NTPC. The

tariff regime and operating models of

some these power generation entities at

that time did not require utmost attention

to projection completion on schedule

and to cost budgets. However, with the

competitive power pricing policy PPP

bids, - wherein one can participate in

developing power, only if you are the

most efficient on capital cost as well as

operating cost - has led to increased

focus on executing projects on time and

within budget. Most projects are being

financed by project finance companies

and financial institutions, who demand

that developers manage the project

budget escalation risks.

Internal teams at even established

generation companies are stretched,

and at the same time, there have been

a large number of new power sector

entrants, some with limited background

in executing large projects. Hence

the entire sector is favourably inclined

towards contracting project execution

on a LSTK basis. The current landscape

indicates that large public or private

sector generation companies like NTPC,

given their internal engineering and

project management talent pool, will

continue to buy individual packages,

keeping the integration to themselves.

However, they may combine multiple

power plants in their portfolio, going for

combined bids to get the best prices and

reducing transactional bidding costs.

NTPC floated a tender for different

packages for 11 units of 666 MW each,

the award of which is likely by first

quarter of 2011. With this move, NTPC

is expecting to bring down the cost/MW

of setting up power plants, which many

experts believe today is at about 5.5

crore/MW7. State level generation

companies, most of whom are currently

on the twin package mode (BTG and

BoP), may continue to procure in that

manner.

The trends in the private sector are

interesting, where a distinction needs to

be made between large business groups

like Reliance ADAG, Essar Group, JSW

Group, Sterlite Group, GMR Group,

Lanco etc who are likely to build large

portfolio of power projects in the future,

vis--vis smaller players with fewer

generation projects in their planned

portfolio.

While complete power plant as a single

EPC/ LSTK package is still rare in the

Indian scenario. Moreover, the trend

of not awarding the entire EPC job (i.e.

both BoP and BTG of a power plant) to

one single service provider has been

driven by:

Distinct set of competencies required

for the BTG and BoP packages.

While BTG is technology, equipment

and manufacturing intensive, BoP

requi res complex integrat ion

capabilities of sub-systems to be

sourced, erected and commissioned

from different sources.

A single LSTK package would amo-

unt to a range of around INR 6000

crores for a typical 2X660 MW

project, requiring EPC companies

with large balance sheet and risk

bearing capability. It will be difficult

to find enough number of such

contractors to get a competitive bid.



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8 Economic Times, 23rd January 2011

Typical Outsourced Package Structure by

Thermal Power Plant Developer Segments

The large business houses like Tata,

Reliance, JSW, Adani have significant

in-house capabilities as far as project

execution goes. Moreover they have

substantial leverage with equipment

vendors and sub-contractors due to

their large portfolios. (Reliance has

demonstrated this by entering in to

an agreement with Shanghai Electric

Company for main plant equipment

supply for all its thermal power plants,

and in the process also getting access to

cheap funds. Estimates put the savings

on financing cost alone at INR 6500 Cr.

for just the Sasan UMPP project being

developed by Reliance Power8.

With that kind of leverage, it is hard

to imagine, large private companies

wanting to outsource setting up of power

plants to EPC companies on a turnkey

basis. If EPC companies are looking

to capture this private sector market in

utility power plants, we believe they will

have to bring a value proposition which

reduces power plant capital expenditure

costs by at least 10 15 percent over the

currently prevailing benchmarks, through

effici

epc industry in india

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