If there has to be a single reason why the balance of power seems to have shifted from EPCs ? engineering, procurement and construction companies ? to power project sponsors it is that those sponsors usually are better capitalised. But that's not the end of the story.

Projects are being completed faster, requiring large EPCs with costly overhead to book more business in an environment of fewer deals and with more of the work on particular projects being taken on by project sponsors. The nature of the business has changed so that contractors often are relegated to the role of assemblers, with turbines and other integral parts of projects being provided by sponsors and brought to construction sites.

Ratings on engineering and construction companies run the gamut, with the highest rated company having an ?A+? rating, and lowest at ?B-?. I believe the median rating on the approximately 40 global construction companies we follow is ?BB,? according to Joel Levington, an analyst in corporate ratings who covers the engineering and construction for rating agency Standard and Poor's.

?As for the reducing number of construction companies, there has been a lot of industry consolidation over the past few years, although the industry is highly fragmented, with the largest construction firm accounting for less than 2% market share in the US. When it comes to power plant construction, however, there are basically three real choices ? Bechtel, Fluor, or Shaw Group,? Levington said.

Levington said that, in general, he would disagree with the assertion that in the past a sponsor had far less leverage when dealing with a contractor. ?Historically ? at least, over the past decade ? contractors have had very little bargaining leverage ? as power plant construction was very modest ? mainly as a result of industry deregulation. As a result, contractors were willing to take on full wrap risks on projects. This led to the bankruptcies of Stone & Webster and, to a large extent, Washington Group.

?There have also been hundreds of millions of charges taken by E&C companies for cost overruns. Today, demand for power plant construction is robust, and, combined with contractors that simply cannot afford to continue to take on full lump-sum risks, we have noted trends of construction companies getting more cost reimbursable work and pushing some of the risk back to the client.

?Therefore, today, the acceptance of project risk is really a function of business strategy for the construction firm. Some, like Bechtel and Fluor, believe that they have sophisticated procedures and are willing to accept lump-sum risks for the potential greater rewards. Others, like Shaw and Jacobs Engineering, are not willing to take on those risks, and do only cost-plus work. When the market turns down, which we are anticipating to be in 2004, these risks may eventually fall back onto the contractor,? Levington explained.

That position was reinforced by Tom Griffiths, project finance specialist at Kansas City-based and privately-held EPC Black & Veatch. ?If a project requires project financing, it must be in place before work begins in order to secure a cash stream. If the client needs us to begin work prior to financing being set in place, we must receive cash, a letter of credit or a parent guarantee for the amount at risk.?

Third quarter and nine month results show a downturn for second-tier power market EPCs, reflecting fewer deals, decreased turnover and shrunken earnings.

Foster Wheeler's EPC group reported bookings were down 9% for the quarter to $675.5 million from $741.9 million in 2000. The group's ending backlog was $4,508 million down slightly from $4,600 million last year. Revenues were $531.9 million compared to $792.4 million the year before. For the first nine months of the year bookings were $1,888 million versus $2,401 million for the same period in 2000. Revenues were down to $1,541 million compared to $2,201 million last year. However, Foster Wheeler is not involved in the power sector to the extent that the other major players are.

By contrast, Fluor Corp's EPC business reported operating profit for the third quarter of $66.4 million, up 16% from $57.1 million in the comparison period for last year. Operating margin improved slightly to 3.8% from 3.4% a year ago. New awards for the EPC segment were $1.9 billion, nearly level with $2.0 billion last year. Backlog increased 7% to $8.2 billion from $7.7 billion a year ago. Gross margin in backlog improved to 7.3% from 6.5% for the fourth quarter in 2000.

The Shaw Group announced an 89% increase in earnings to $19.3 million for the three months ended August 31. This compares to earnings of $10.2 million before an extraordinary item, for the three months ended August 31, 2000. Fourth quarter fiscal 2001 sales increased 46%, reaching $385.7 million, compared to $263.8 million for the fourth quarter of fiscal 2000.

For the year ended August 31, the company reported a 101% increase in earnings to $61.2 million before an extraordinary item. This compares to earnings of $30.4 million before an extraordinary item and cumulative accounting change, for the year ended August 31, 2000. Sales for the year ended August 3 increased 102% to $1.5 billion, compared to $763 million in sales for the year ended August 31, 2000.

Shaw's backlog totalled $4.5 billion at August 31, with approximately 42%, or $1.9 billion, to be worked off during the next 12 months. Driven primarily by strength in the domestic power market, this represents a 137% increase over the $1.9 billion backlog reported at August 31, 2000, and a 25% increase over Shaw's backlog at May 31 of $3.6 billion.

John Kunkle, senior director of the project finance unit at Fitch Ratings, maintains that the trend by sponsors to build multiple power plants has diminished some contractor responsibility. ?The shift on power deals is moving back to sponsors. The argument is that construction has become such a cookie-cutter process that much of the design and specification process no longer is necessary.?

Kunkle adds that investors don't want to rely on completion guarantees from contractors, but look to sponsors. ?It will be interesting to see what happens as the US goes into recession, with fewer projects started. And those that are started may be constructed over shorter periods of time.? Kunkle notes that even swollen order books will not ensure long-term survival for EPC companies. ?Projects with diminished contractor input may take six to nine months to complete whereas the same project might have kept a contractor on the job for two or three years.?

Consolidation also will continue to mark the EPC sector because of the global economic downturn. And the fewer projects will mean slimmer margins as competition heats up. ?I think it will be a tough ride for some EPC contractors,? Kunkle maintains. ?It also depends on corporate strategy.

?Companies like Calpine, with very aggressive growth targets, don't want to be slowed down by a process. For instance, Calpine places orders for turbines well in advance. And with a track record and critical mass, these companies get corporate style financing from lenders, and can utilise in-house expertise to assume some of the responsibilities previously shouldered by EPC contractors.?

That insight is only partially true, according to a spokesman for the Washington Group International, a large EPC which acquired Raytheon Engineers & Constructors (RE&C) in July 2000. Brent Brandon, Washington Group vice president, attributes the market shift to be due primarily to the dynamics of supply and demand.

?The evolution of the business model in the power EPC market is driven by two fundamental issues: the limited supply of qualified EPC contractors with the resources and experience necessary to perform; and, the market's need to adjust the equilibrium of risk sharing and spread risk more equitably among participants.?

Washington Group should know something about the subject as the company in late November had its reorganisation plan, which features a debt for equity exchange, approved by an Idaho bankruptcy court. The company filed for bankruptcy in May. Court-appointed examiner KPMG determined that Washington Group's bankruptcy was precipitated by the RE&C transaction and acquisition financing. The former Morrison Knudsen doubled in size with the acquisition of Raytheon's engineering and construction unit in 2000.

The plan also calls for settlement of outstanding litigation between Washington Group and Raytheon Co. The company's secured lenders will receive 80% of the primary equity in the newly reorganised company and $20 million in cash. The company's unsecured creditors will receive 20% of the primary equity in the company along with the right to purchase, through warrants, up to an additional 25% of the company's new common stock over four years.

Washington Group had charged RE&C of delivering two, unaudited, ?blatantly erroneous balance sheets,? and ignoring hundreds of millions of dollars of balance sheet adjustments. Washington Group has accused Raytheon of defrauding it last year in the sale of the construction division for $53 million and the assumption of an estimated $450 million in liabilities.

However, Suzanne Smith, a director in S&P's project finance group, said it was not just power projects losses on RE&C jobs, but also from losses in infrastructure and government service sectors that hobbled Washington Group as well. ?Furthermore, Washington continues to work in some capacity at all of the RE&C projects, including the Sithe ones today.?

Baker & McKenzie partner James O'Brien said in a Project Finance article in May: ?(In the past) single asset project financings by under-capitalised sponsors needed lump sum EPC contracts. Large creditworthy EPC contractors stepped in to take the risk of construction delay, performance and cost overruns because the sponsor's completion guarantee was not enough. Sponsors paid a 10% to 20% premium over the estimated construction costs, but investors demanded coverage for the construction risk.?

That is not necessarily the case, according to S&P's Levington. ?It is not always a question of sponsors' completion guarantees not being enough, but more of an issue of sponsors not willing to provide the guaranties because they didn't want to assume the liability associated with the guaranty.

?Many EPC contractors had to have their performance further backed up by performance bonds and letters of credit because they were not sufficiently creditworthy. The 10% to 20% premium reflects, in part, the value the sponsors put on not having to guaranty construction themselves.?