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Expert opinion
13 April 2022

Inflation and EPC finance: Another case of history repeating?

Infrastructure, Manufacturing & equipment, Transport
Head of Trade, Treasury and Risk
EPC contractors are having to deal with the inflationary ripples from the pandemic and the invasion of Ukraine. It’s 100 years since one attempt was made to reconstruct central and eastern Europe and nearly 50 since the last major oil shock. Are there lessons to be learned?

“History doesn't repeat itself, but it often rhymes,” said Mark Twain, or if he didn’t he should have. Are there lessons to be drawn by EPC contractors from past inflationary shocks a century and 50 years ago? 

Engineering, Procurement and Construction (EPC) contractors are already facing the ripple effects of the Ukraine crisis and sanctions on the back of the COVID-19 pandemic. “We were very actively following a serious prospect in Ukraine for a new ring round around Kyiv before the invasion and UKEF were on board. Ukraine will come back again eventually but sadly in a very different way as a major infrastructure rebuilding programme will be needed,” says Chris Perrins, senior director EMEA finance, at the US civil engineering company Bechtel. Even at this early stage, estimates for damage and reconstruction range from $220 to $540 billion. 

But the secondary impact of the crises has been inflationary pressures in supply chains. “We’re seeing cost inflation for engineering projects for EPCs, and the ripple effect is hitting Europe in particular too,” says Gabriel Buck, managing director at GKB Ventures. But what are EPC contractors actually seeing in terms of increasing costs within their supply chains? "There are going to be inflationary costs of equipment,” Buck says. “Even in the clean technology space, how much energy is needed to make a turbine is significant and this could skew calculations for the energy transition." 

Rhymes from time – a century and 50 years

It’s exactly 100 years this week since the Genoa conference which discussed the economic reconstruction of central and eastern Europe and tried to explore ways to improve relations between Soviet Russia and European capitalist countries. The 1922 conference papers were specific, such as “facilities and guarantees for the import and export of commercial products,” and designed to be preparations for future prosperity and not Versailles reparations for past deeds. 

There was also a movement towards the resumption of the gold standard, which would last in some form for 50 years until suspended by US President Richard Nixon in 1971. (Gold is back in the headlines this week as Russia attempts to fix its currency with the metal. This, however, as history does show, has not ended well.)

Gold got old, try Texas tea  

Worldwide domestic inflation in the 1970s and an expensive war may have forced Nixon’s hand. Conventional wisdom is that inflation can be tamed by raising interest rates – a nice convention in closed economies, but not with globally traded commodities. The oil price shock of the 1973/4 OPEC oil crisis crippled the world economy and major exporting industries in the 1970s. Export subsidies were banned but preferential export financing (insurance ‘dough’ with ‘sprinkles’ on top) proved ruinously expensive too and the costs prompted the evolution of the OECD Consensus in 1976 in response to export subsidy ‘dumping’ and which became the Arrangement in 1978. 

Modern world challenges for EPCs – selective and time lag tendering

Back in the world of modern EPC contractors, there is differential inflation in their inputs (think lots of small things such as the bolts to go into a big thing such as a turbine or a ship) ranged against the trend general increase in interest rates. Those different supply chain pressures today have big implications for tendering. This can be summed up as time lag tendering and selective tendering.

Certainly, inflation will impact the time value of contracts. As Andreas Back, senior manager, financial services at Wartsila told TXF. “Many companies these days have challenges in maintaining the traditional way of offering to grant a certain price and a certain delivery time for the offer period. That is getting shorter and more difficult to maintain over a long time period.” He adds: “When you put in a proposal the gap in terms of costs for what you actually can offer to deliver is now shorter. Those costs can be impacted unless we are mitigating them in the offering stage. Indicative offerings have been here for many years, but now indicative offerings have more disclaimers stating things like, ‘due to the global situation…’ That means unless we sign within the foreseeable future, guaranteeing strict timetables is a challenge.”

With EPCs facing increases in energy, equipment costs and even for the clean technology space, is cost-push inflation hitting their pricing? Says Back, “It's fair to say that there's global inflation on all levels and also the sub supplier levels. That's directly or indirectly affected by these two things, depending on the work, because you have some suppliers that may be sourcing from a country that is having to reroute from Ukraine for instance. Essentially, prices are affected for anything from global commodity prices or, for instance, battery storage – that’s on the manufacturing side, on some supplies or raw materials side. 

“Therefore, it's very hard to maintain or predict price levels for a long time. Of course, if we make an offer today, we are able to sign it today and we're able to sign it tomorrow and the day thereafter. But if somebody comes back after the six months and said, “hey, you made me this offer,” it would be different.”

Fixed pricing is “a fool’s game”

Perrins at Bechtel emphasises selective tendering. He continues to be busy with other prospects (he’d just come back from Tirana when he spoke to TXF). “We closed a deal in Serbia last year, North Macedonia is interesting and also Poland,” he says. “The challenge for EPCs is backing the right horse and not getting into too many heavily competed tenders as you are not going to win every one and the sunk costs can be huge. We try to pursue more niche opportunities but it is a fine line of course because many funding institutions either require or expect to see transparency around bidding and value for money auditing and the governments we work with invariably need all the funding there is.“

Inflation is a reality. “Prices are forever going up,” says Perrins. “You just have to build in a mechanic to allow for that. Fixed pricing is a fool's game and always ends badly.”

Energy security needs

“Energy security is a real priority for the governments we are speaking to currently and we see a key role for ECA financing to support. The sovereign bond pricing in the Balkans for example has spiked by around 150 basis points since the Ukraine invasion, so the gap between ECA and other funding sources has widened markedly. That is before you add in the longer tenor and reduced negative carry benefits,” Perrins notes. 

Are energy security needs going to see some ECAs and governments taking feet off the pedal on their environmental concerns too? “For environmental, too soon to say really but I am not sensing that there will be relaxation. It's just such a thorny issue now and nobody wants adverse publicity,” Perrins says.

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