Coal, Gas

Long-Term Service Agreements: Top 10 Contractual Pitfalls and How to Avoid Them – Part I

Issue 2 and Volume 107.

by: Richard E. Thompson II and Jason B. Yost, Troutman Sanders LLP

Long-term equipment maintenance and service programs are known by many names: long-term maintenance programs, contractual service agreements, and perhaps most commonly, long-term service agreements, or LTSAs. Sooner or later, power generation equipment owners worldwide are likely to come face to face with these behemoth documents. While many Owners are entering into an LTSA for the first time, others are realizing the challenges of implementing LTSAs that were entered into when the equipment was first ordered years ago. Still other Owners are faced with analyzing LTSAs that they themselves did not negotiate, but that they have instead inherited as part of an asset acquisition.

LTSAs typically commit the original equipment manufacturer (OEM) to providing, on a relatively “fixed-priced” basis, maintenance services for the very equipment that they manufacture (e.g., gas turbines, steam turbines, etc.). Commercially speaking, LTSAs can offer many advantages to Owners, including the predictability of relatively fixed long-term maintenance costs and contractually guaranteed or incentivized OEM support. However, these very complex agreements can often contain pitfalls for the unwary equipment Owner – pitfalls that can cause an Owner to bear an inordinate amount of risk, or may result in costly and time-consuming disputes with the OEM.

null

This two-part article examines the Top 10 contractual pitfalls most commonly found in LTSAs, and suggests appropriate means for avoiding them. Part I, in this issue, presents the first five, and Part II, in the March issue, will present the second five.


GE Frame 7FB gas turbine.
Click here to enlarge image

As no two LTSAs are alike, this article assumes an LTSA whereby the OEM’s work scope is limited to performing: (i) all regularly “scheduled” maintenance on the equipment, on a “relatively fixed price” basis; (ii) all “unscheduled” maintenance work on the equipment, on a “relatively fixed price” basis; and (iii) certain “Extra Work” as may be requested by the Owner, on a unit-priced basis.

Pitfall 1: Clearly Defining Scheduled Maintenance

As basic as it may sound, one of the most common pitfalls in LTSAs is the lack of a clearly defined scope of the OEM’s responsibilities for providing scheduled maintenance on the equipment. The risks an Owner faces from such a lack of clarity can be tremendous and costly, especially in the context of an LTSA that contains fixed-pricing for scheduled maintenance work (the corollary to which is typically that work outside of the OEM’s defined work scope costs extra). For instance, imagine an Owner whose gas turbine has just been taken offline for its first scheduled major maintenance outage. The Owner believes that the OEM will provide all parts that may be necessary as part of its scheduled maintenance work scope. Suddenly, however, the Owner receives notice from the OEM that it is waiting for the Owner to replace certain thermocouples, oil filters and other spare parts as part of such maintenance. Or worse yet, the OEM goes ahead and replaces such spare parts and bills the Owner for such work, in addition to its normal invoice for scheduled maintenance. The response echoes from the plant site to company headquarters: “Wasn’t that part of the OEM’s work scope?!”

The way to avoid this pitfall is as basic as the pitfall itself: the LTSA should clearly and completely define the OEM’s work scope with regard to scheduled maintenance. First, the work scope should include a complete list of all component parts of the equipment that are subject to OEM-scheduled maintenance obligations. Second, it should describe the general nature of the OEM’s scheduled maintenance obligations with respect to each such part (e.g., inspect, repair, refurbish, replace, etc.). Third, the work scope definition should include a description of activities for each scheduled maintenance outage, outlining the OEM’s obligations with respect to the same.

Ideally, the contract should also specifically list any parts or activities that are not included in the OEM’s scheduled maintenance work scope, with express language that such exceptions are the only exceptions. Finally, as a “catch-all” concept, it is helpful to define the goals of the overall scheduled maintenance program (e.g., high availability and maximum output) and require that the OEM’s scheduled maintenance work scope include any other activities required to meet those goals (this is especially recommended in the absence of OEM guarantees regarding equipment performance). With each of these components present in the LTSA’s definition of scheduled maintenance work scope, the risk of disputes regarding what is and is not covered as part of the OEM’s scheduled maintenance work scope will be minimized, to the benefit of all parties involved.

Pitfall 2: Clearly Defining Extra Work

Most LTSAs include a concept known as “Extra Work.” This concept enables Owners to request that the OEM perform various services that are not normally included in its standard work scope. For example, the Owner may ask the OEM to repair or replace certain parts of the equipment that are normally “inspect only” components, meaning that the OEM’s regular obligation with respect to those parts is limited to inspecting them and then notifying the Owner of any irregularities. The OEM can then either agree to perform such “extra” work or not. Extra Work provisions are typically structured so that if the OEM agrees to perform such work, then the provisions of the LTSA will govern the parties’ obligations related to such Extra Work. Thus, the parties avoid having to negotiate an entirely new contract for each instance of Extra Work. Compensation for such Extra Work, which is payable in addition to the “normal” payment scheme for scheduled maintenance, is frequently based upon an agreed pricing schedule. While this “standard” concept of Extra Work is intended to be simple and straightforward, this simplicity can easily be shattered when additional concepts are forced under the rubric of an Extra Work definition.

The concept that is most commonly “forced” into an Extra Work definition involves defining “Extra Work” to include extra parts or labor that become required for the OEM to perform its “normal” scheduled maintenance work scope as a result of certain circumstances. Typically, these are events for which the Owner bears the risk under the LTSA (e.g., the Owner’s operation of the equipment outside certain expressly assumed parameters). Thus, a provision might read that “Extra parts or labor to perform scheduled maintenance that becomes required as a result of Owner’s operation of the equipment in a manner other than as expressly assumed in this agreement shall constitute Extra Work.” Such a typical provision is flawed from its inception, because it mislabels normally required scheduled maintenance work as “Extra Work,” when in fact, there is nothing “extra” about the OEM’s performance of such work.

To illustrate this point, imagine an LTSA that expressly assumes that the Owner will operate the gas turbine at a baseload level, with a high overall annual hours/starts ratio. If market conditions change such that the Owner instead operates the turbine as a “peaker” unit, with a lower annual hours/starts ratio, then the OEM may be required to perform a combustion inspection that would not otherwise have been required under a baseload operating profile. The additional combustion inspection should, by definition, be part of the OEM’s required scheduled maintenance work scope under the LTSA; an unforeseen part of it, but a part of it nonetheless. However, an Extra Work provision like the one described above would inadvertently label such work as “Extra Work.”

Often, the motivation behind this blending of concepts is that the parties want the additional costs of such extra parts or labor to be chargeable based upon the same pricing schedules that happen also to apply to “standard” Extra Work. Thus, the shortcut is simply taken to label such extra parts and labor as “Extra Work,” so that they are priced as such. However, such a shortcut results in a fundamental inconsistency between the concept of Extra Work being provided per the Owner’s request (with OEM discretion to accept or reject the proposed work) versus the concept of maintenance work that is already required to be performed by the OEM (i.e., without need of a request by the Owner and without the ability for the OEM to elect not to perform the work). Such an inconsistency creates risks for the Owner insofar as the LTSA may be interpreted to make certain scheduled maintenance work “optional” to the OEM pursuant to the standard Extra Work concept. Would the extra combustion inspection described above be “optional?” This would certainly not be the Owner’s intention, but this contractual pitfall could lead to that interpretation.

In addition, further risks arise when other LTSA provisions relating to Extra Work inadvertently apply to portions of the OEM’s work scope that are not at all intended to be “extra.” For example, if an LTSA provides that the OEM’s warranty obligations under the LTSA do not apply to Extra Work, then the contract could be interpreted so that certain scheduled maintenance work (mis)labeled as “Extra Work,” may not be warranted at all!


Gas turbine combined-cycle plant based on Pratt & Whitney’s FT8 Twinpac.
Click here to enlarge image

null

To avoid this pitfall, Owners must avoid blending the “standard” concept of Extra Work with the concepts of scheduled and unscheduled maintenance. All of these concepts should be kept separate and distinct from each other. The parties should strive to keep the definition of Extra Work “short, simple and separate” so that it applies only to optional work that is not included in the OEM’s “normal” maintenance work scope. In addition, Owners should insist that the LTSA include a complete and specific list of all items of maintenance that are not included in the “relatively fixed” pricing of the LTSA. Regardless of the status of such items, this list should not be labeled as Extra Work in the LTSA. Instead, the LTSA should simply describe the basis for pricing such items in a provision of the LTSA that is separate from the provisions discussing the basis for pricing Extra Work. The language may be repetitive insofar as these two pricing bases may be parallel; however, the resulting clarity will be well worth such repetition.

Pitfall 3: Appropriately Allocating Prolonged Start-up Risks

In the typical LTSA, the OEM provides maintenance for equipment that the OEM itself has sold to the Owner under separate contract (perhaps via an OEM affiliate). Under most standard equipment procurement contracts, the OEM would have certain obligations to ensure that the equipment is capable of achieving commercially operational performance levels. An OEM, in trying to meet such obligations, may spend weeks at a site troubleshooting equipment commissioning issues. During this time, the equipment may be repeatedly started-up, run for several hours, and then (intentionally or unintentionally) shut down. Finally, the long awaited day arrives when the equipment “goes commercial,” and the champagne corks fly.

Often, however, it is in the LTSA that the hangover is hidden. After all, the pricing for many LTSAs is based upon the number of “hours” of equipment operation or the number of equipment “starts,” or a combination of both. In many an LTSA, such pricing basis fails to distinguish between hours and/or starts occurring before or after the commercial operation date (COD). As a result, such pre-COD hours/starts can be charged to the Owner under the LTSA, even if they resulted from defects in the OEM-provided equipment. Thus, a smart Owner will insist that it is most appropriate for the OEM to shoulder this risk completely, so that all pre-COD hours and starts related to equipment defects are not charged under the LTSA. An even smarter Owner will make certain, through careful negotiation and communication, that the OEM does not simply premium price this risk into the LTSA, so that the Owner ends up paying for the assumed potential costs associated with this risk, whether they are actually incurred or not.

Pitfall 4: Protecting Owner Interests in the Absence of Performance Guarantees

Consider this scenario: An Owner’s equipment suffers an unscheduled outage during the summer peak period. The Owner desperately needs to get the equipment back up and running, and the LTSA requires the OEM to handle the job. But how can the Owner ensure that the OEM is focused on the same objective, namely, returning the equipment to revenue producing operation as soon as possible? Often, this is accomplished through contractual guarantees regarding OEM performance under the LTSA. Performance guarantee provisions normally provide financial incentives (e.g., bonuses and/or liquidated damages) that help ensure that OEM response time for unscheduled outages is immediate, that scheduled (and unscheduled) maintenance outages are completed quickly and efficiently, and that the reliability level of the equipment is as high as possible. Frequently, however, overall project economics, which are affected by such financial incentives, result in LTSAs being executed without such performance guarantees. Thus, Owners are faced with the issue of how an LTSA can be structured so as to provide the correct incentives for OEMs to meet the required level of service without financial impacts on project economics. A common pitfall in LTSAs is the absence of these non-financial incentives altogether.

Owners can avoid such pitfalls by insisting that their LTSAs establish contractual requirements for OEM behavior, with clear, non-financial remedies if such requirements are not met. For example, an LTSA can mandate a given response time for unscheduled outages or set maximum outage time requirements for scheduled maintenance outages. Furthermore, an LTSA can require that the OEM’s services be provided in a manner that generally ensures a minimization of unscheduled outages for the sake of overall plant reliability.

Once the parties have agreed upon such desired objectives, the LTSA should then include one or more clear Owner remedies for violations of these requirements. For example, if, as described above, the OEM is not adequately responding to an Owner emergency as a result of an unscheduled outage, then the Owner may want the clear contractual right to perform the necessary work itself in order to return the equipment to commercial operation as quickly as possible. The Owner will then want to outline a contractual right to backcharge the OEM for costs resulting from the Owner’s having to perform such work. As an ultimate remedy, Owners should insist that repeated or substantial violations of performance requirements by the OEM will amount to an outright contractual default, allowing the Owner to terminate the LTSA for cause.

Pitfall 5: Clarifying Responsibilities Between Unscheduled Maintenance and Warranty Obligations

Imagine this scenario: An expensive capital part in the equipment breaks, causing an outage. The Owner calls the OEM’s on-site technical specialist to the scene, and both of them have their LTSA copies in hand. As pages are turned, one thing is clear: the OEM will have the responsibility to address the outage under the LTSA. What is not clear, however, is whether the cost of performing such work will fall on the Owner or the OEM. One read of the LTSA would require that such part be repaired or replaced under the OEM’s contractual warranty obligations. Assuming that the warranty is in force, under a typical warranty provision, it would be standard fare for the OEM to repair or replace the part at its own expense. However, an alternative read of the contract would focus on the fact that an unscheduled outage occurred, and that the OEM’s primary obligation is to perform the “unscheduled maintenance” work required to remedy the outage. Depending upon the way that unscheduled maintenance is paid for under the contract, the costs of the OEM’s performing such work could be borne entirely by the Owner. Which interpretation is the correct one?

Here again is a pitfall that frequently results from the complexities of an LTSA. And once again, the way to avoid this pitfall is somewhat simple (and a recurring theme throughout this article): draft for clarity. A single sentence requiring the OEM’s warranty obligations to take precedence over its unscheduled maintenance obligations would, in this situation, settle the issue in the Owner’s favor from the very beginning.

Such are the first five of the “Top Ten Contractual Pitfalls” for LTSAs. As their very name implies, LTSAs will be here to stay for a very “long term.” Thus, the pitfalls found in these complex documents simply cannot be ignored. The second five of our Top Ten pitfalls will be covered in next month’s edition of Power Engineering magazine.

Authors –

Richard Thompson II and Jason Yost are both attorneys with Troutman Sanders LLP. Troutman Sanders’ LTSA Team has unparalleled experience in structuring, drafting, analyzing, negotiating and implementing long term service agreements for power generation equipment. Collectively, the Team has negotiated and advised upon LTSA transactions for more than 120 gas turbines and 70 steam turbines. These include transactions involving services from all of the major power generation original equipment manufacturers in more than 15 different U.S. states and in Europe, South America and the Caribbean.