Legal Briefing

NEC3 – the nuclear engineering contract?

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Projects, energy and natural resources | 01 September 2011

It has become the standard suite of construction and engineering contracts in the nuclear decommissioning sector, EDF is currently using it for the early packages at its Hinckley C development in Somerset and Horizon Nuclear Power has been taking soundings from the nuclear supply chain as to its suitability for its proposed new nuclear power plants at Oldbury and Wylfa1. This family of contracts, the third edition of the New Engineering Contract (NEC3), has become so popular in the nuclear sector that it may soon be known as the Nuclear Engineering Contract (NEC). But why has it become so popular? And is its popularity justified?

WHY IS NEC3 SO POPULAR?

Until recently, NEC3 had largely been confined to public sector projects, where its use is effectively mandated, and projects procured by a relatively modest number of private sector supporters, such as BAA plc (who has used NEC3 for its capital projects, including terminal 5 at Heathrow, since it was recommended by Sir Michael Latham in the mid-90s)2. Outside the nuclear sector, NEC3 has been ignored by the wider energy sector in favour of more tried and tested suites of contracts, such as those published by The International Federation of Consulting Engineers (FIDIC), which are well known to and understood by investors, developers, the supply chain and funders3. So why has NEC3 been embraced with such vigour by the nuclear sector?

Undoubtedly, the support given to NEC3 by the Nuclear Decommissioning Authority (NDA), which was created under the Energy Act 2004, is a key factor. This has led to consultants and contractors experienced in working on the NDA estate – who are skilled in the procurement of capital projects on nuclear licensed sites (pursuant to the Nuclear Installations Act 1965) and keen to transfer those skills to the development of new nuclear power plants – becoming strong advocates of NEC3. We believe this support is derived from an appreciation of how the following key features of NEC3 may complement the rigorous safety, process-focused culture that is engrained in the nuclear sector and necessary to ensure that all nuclear installations meet the exacting standards demanded by the industry, regulators and the public.

Project management tool

NEC3 is regarded as a hands-on project management tool, not just an expression of how key project risks have been allocated between the parties to be retrieved only when the parties fall out. NEC3 achieves this through the following key principles.

Plain English

Unlike other engineering contracts, NEC3 avoids cross-referencing and uses the present tense, emphasising its desire to be used as a management tool by project managers and other construction professionals.

Early risk identification and management

All construction and engineering contracts oblige the contractor to flag up risks that may delay or increase the cost of the project. However, NEC3 is different in a number of respects. It places an obligation on both parties to flag up such risks and, crucially, any risk that may adversely effect the operation of the plant (see core clause 16.1). NEC3 also clearly links the obligation to a number of other related terms, including a risk register regime. The regime obliges the parties to consider how best to manage any risk and allocate responsibility for agreed actions, and the calculation of compensation to the contractor for employer risk events (known as compensation events) by allowing the effect of any failure by the contractor to provide an early warning to be taken into account. It also uses terms such as ‘early warning’ and ‘risk register’, which elevate the obligations to a status that the equivalent terms in other contracts appear to lack. This serves to further the project management function of the contract.

Swift agreement on the cost and time effects of employer risk events

NEC3’s key priority is addressing matters as they arise so that their effects are agreed and all parties work towards clear targets in relation to plant performance, time for completion and cost. It achieves this by clearly allocating project risks between the contractor and the employer, and by a compensation event regime that requires the contractor to provide a statement of the time effect (through amendments to the project programme) and cost effect of any compensation event within a stringent time period. Any failure to comply will result in the contractor losing their entitlement to extra time and money (see core clause 61.3).

Detailed programming obligations

Most other forms of construction and engineering contracts contain very modest obligations on the contractor to produce and revise programmes throughout the duration of the project, limited in most part to the production of a master programme at the beginning of the contract. In stark contrast, NEC3 contains very detailed terms prescribing what the programme for the works is to show and obliges the contractor to update the programme on a regular basis.

Accommodating all procurement strategies

NEC3 adopts a flexible approach to the development of the contract terms to meet the chosen procurement strategy. It contains core clauses that apply in all circumstances and a choice of main option clauses to reflect the chosen method of procurement. For example, main option A provides for a fixed price apportioned against an agreed list of activities suitable where the scope of work is clearly understood. At the other end of the scale is main option E, which provides for payment of the actual cost incurred by the contractor where the scope of work is too uncertain to be capable of being priced upfront. NEC3 also includes a choice of two dispute resolution options and a range of secondary options addressing a variety of common issues (such as price inflation, changes in law, limitations of liability, provision of a performance bond and parent company guaranty)4. Several of these issues will be selected to meet the particular needs of a project.

Collaboration

NEC3 seeks to avoid the traditional adversarial approach to contracting. It encourages the parties to adopt a collaborative approach to fulfilling their obligations under the contract through the project management principles discussed above and more direct means, including in the first clause of the contract, which obliges the parties to act in ‘a spirit of mutual trust and co-operation’ (see core clause 10.1).

IS NEC3’S POPULARITY JUSTIFIED?

NEC3 has clearly been embraced by the UK decommissioning sector and appears to be working well. However, it remains to be seen how well it will perform in relation to the development of new nuclear power plants, which present different challenges.

Appeal to international supply chain

Similarly to offshore wind, the other major development programme underway in the UK’s energy sector, the nuclear supply chain is likely to be heavily populated by contractors and technology vendors based outside the UK. For example, the reactor designers Areva and Westinghouse are based in France and America respectively. Foreign vendors and contractors are used to contracting on more traditional engineering agreements, which are well known to their internal and external advisers, investors and funders. NEC3 has not been extensively used outside the UK and is therefore relatively unknown. This may concern some members of the international supply chain because it looks and feels substantially different to traditional engineering contracts.

NEC3 is very different to a traditional FIDIC contract in its use of the present tense; the absence of cross-references; its use of two sets of defined terms and unusual terminology (such as ‘works information’ instead of ‘specification’); and the modular way in which the terms are constructed (such as core, main option, dispute resolution and secondary option clauses). Alongside the very different way in which certain key risks are addressed, this divergence is likely to add to the unease felt by advisers.

NEC3’s core clauses do not contain an express design warranty and therefore impose an obligation on the contractor to provide a design that will be ‘fit for purpose’ under English law. This implicit obligation may be reduced by the adoption of secondary option X15 to one of ‘reasonable skill and care’ but, unlike most standard forms, it is the contractor (not the employer) who must prove that they have reached this standard to escape liability. Site risks are also addressed in a more subtle way through their inclusion in the wording of one of the compensation events, rather than in a standalone clause (see core clause 10.1). The time bar to claiming additional time and money for a compensation event is also unique to NEC3, and may have a dramatic effect on the contractor if its effect is misunderstood or overlooked. Developers who wish to use NEC3 should therefore consider investing in an education programme (including facilitated workshops) to ensure that all vendors and contractors are sufficiently familiar with the key principles and processes to be able to price and implement them effectively, thereby avoiding payment of an NEC3 risk contingency.

NEC3 language is not tried and tested

Advocates of NEC3 cite its plain, present-tense drafting as one of its major benefits. However, the apparent simplicity of its language has been criticised in the few cases where it has received close inspection. In particular, the following comment by Edwards-Stuart J in Anglian Water Services v Laing O’Rourke Utilities [2010] on NEC3’s use of the present tense has received significant attention:

‘No doubt this approach to drafting has its adherents within the industry but… from the point of view of the lawyer, it seems to me to represent a triumph of form over substance.’

A number of distinguished QCs are also highly critical of the language of NEC3, which they say is far more difficult to interpret than more traditionally drafted forms and lacks a significant body of binding case precedents to aid interpretation, unlike more traditional forms, such as FIDIC contracts. This will be a concern for advisers as they will be reliant upon their own interpretation of the terms and the guidance that is provided by the publishers of NEC3, which isn’t binding on the parties and may not reflect the interpretation a judge or arbitrator would give to any terms that may be disputed in formal proceedings.

In particular, the obligation to act in a ‘spirit of mutual trust and co-operation’ has proved very challenging. If you query a claim made by a contractor, are you in breach of your obligation? The ambiguity in this fundamental, all-pervasive clause has led a number of users to remove it from the binding part of the agreement and place it in the non-binding recitals. However, there are risks associated with this approach as the recitals may be used to interpret the binding provisions of the agreement5.

Unattractive to funders

The fact that the language of NEC3 is not tried and tested will be a major concern to potential funders. Funders (and their advisers) are cautious by nature and are likely to be resistant to the use of NEC3, preferring more ‘bankable’ forms of contract, such as those published by the FIDIC. This issue may be enough to put off developers who wish to keep their funding options open.

Key issues are not adequately addressed

Another potential drawback of NEC3 is that it does not adequately address a number of key issues relating to power plant development. Some of the most notable examples are as follows.

Health and safety

Reducing risks to health and safety during the development and operation of a nuclear power plant is of paramount importance. However, NEC3 has only this to say on the subject (in core clause 27.4):

‘The contractor acts in accordance with the health and safety requirements stated in the works information.’

The works information will be a collection of documents that specify and describe the works, stating any constraints on how the contractor is to provide the works (including, but not limited to, any health and safety requirements). It has to be developed from scratch for each project as no model drafting is provided. Therefore, there is a clear risk of issues falling between the cracks if those responsible for preparing the works information are not familiar with how it is intended to interact with the terms of NEC3.

Compliance with statutory requirements

The development of a new nuclear power plant is subject to rigorous regulation and various statutory requirements. For example, the licences granted to developers contain widely drafted conditions relating to the design, construction, testing, commissioning and operation of the plant that need to be developed into detailed proposals and agreed with the regulators. Reflecting these statutory requirements in the contracts with the supply chain is therefore a key issue for any developer. However, NEC3 does not contain an express obligation on the contractor to comply with such statutory requirements. The contractor’s main obligation is to ‘provide the works in accordance with the works information’ (see core clause 20.1). Therefore, all such requirements must be set out in detail in the works information or a bespoke set of additional clauses. This is likely to be a challenging issue during negotiations, where there is tension between the developer’s desire to provide as much flexibility as possible in relation to compliance with any regulatory requirements (the details of which may not have been finalised at the time of entering into the contract) and the contractor’s desire for certainty about what will be adequate for the purposes of discharging its related obligations to the developer.

Testing the performance of the plant

Although NEC3 contains terms for testing the works before completion and transfer to the developer, it is does not include a regime for testing the performance of the plant during the post-transfer warranty period. All power plant developers expect the key providers to warrant the performance of their plant for a period of time after it has been handed over. This warranted performance is expected to be tested in accordance with a pre-agreed procedure, with liquidated damages or other remedies made available should the test results reveal sub-standard performance. NEC3 contains a secondary option providing for the payment of low performance damages (in secondary clause X17.1):

‘… if a defect included in the defects certificate shows low performance with respect to a performance level stated in the contract data.’

However, this mechanism does not adequately address this issue without further drafting to set out the testing procedure to be performed to determine whether a defect exists. All other commonly used forms of contract have detailed drafting that provides a robust starting point for adapting the agreement to meet specific project requirements.

Intellectual property

Another weakness of NEC3 is the superficial way it deals with the key issue of intellectual property (IP) rights. IP rights will be a sensitive issue for both developers and technology vendors. They will need to be carefully discussed and terms crafted to reflect the agreed position. Whichever standard form of contract is chosen, the IP clauses are likely to require further development. However, the copyright licence contained in NEC3 is so ambiguous that most parties will be inclined to replace it (see core clause 22.1) altogether.

CONCLUSION

There is no doubt that the emphasis throughout NEC3 on robust project management and collaborative working is an extremely attractive feature that complements the nuclear sector’s relentless focus on the identification and rigorous management of risks associated with the development and operation of nuclear power plants. The key to harnessing these potential benefits is the careful selection of personnel who understand NEC3, are properly resourced and highly motivated to adhere to its principles. However, NEC3 does have several significant drawbacks. Its unconventional language is likely to alienate funders and may make it difficult to sell to some members of the international supply chain (to the detriment of developers). Compared to more conventional rivals, such as the FIDIC family of contracts, some key issues associated with power plant development are dealt with far too superficially, requiring the development of detailed terms to close the gaps.

Notes

  1. Horizon Nuclear Power is a joint venture between E.ON UK and RWE npower.
  2. See Constructing the Team: The Latham Report (1994).
  3. The ‘yellow book’, Conditions of Contract for Plant and Design-Build for Electrical and Mechanical Works and for Building and Engineering Works Designed by the Contractor.
  4. The former depend on whether the contract is governed by the Housing Grants Construction and Regeneration Act 1996, the implications of which are outside the scope of this article.
  5. See HHJ Lloyd QC in Birse Construction Ltd v St David Ltd [1999].