EPC Driving Growth Efficiently Report FINAL

Dear reader,

As the World Bank has recently asked the Roads Ministry to develop new models to expedite projects, India’s Planning Commission envisages a fresh policy on EPC in road projects. Under the new EPC model, the contractor will accept the risk and responsibility for both the design and the construction of work. So while EPC projects have existed, the emphasis on them is freshly brewing.

There is a crying need for more professional process in public procurement, better understanding of quality thresholds and technology among (especially) government and public sector developers. The government will soon have a new law in procurement and may introduce a Department of Procurement. This should come as good news to everyone who is aspiring to reach international quality standards and new technology. Most industry experts believe our contract system—not procurement alone—needs major reform. International developers and investors are demanding better processes and adherence to health, safety, environment norms.

As internationalization knocks on India’s doors, however, high attrition and lack of labour—especially skilled labour—persists. Thanks to governments in traditionally underserved but overpopulated regions such as Bihar, Orissa and Bengal—from where labour typically migrates en masse to where the action is—developmental and infrastructure projects are coming up aggressively. The government-sponsored MGNREGA, which guarantees employment in rural areas, is another reason.

Delays in our development projects are forcing more developers to go the EPC way. The new emphasis on EPC is also, sadly, because investments are looking south. With a double-dip threat in the global economy, the worst industrial growth in eight quarters in India and projects down to a trickle, EPC is a stable option. But if the recent success of India’s largest-ever highway bid-out is any indication, some sectors are all set to change the trend—even as power projects remain suspect owing to poor health of the distribution companies.

We’re proud to present a joint paper that outlines and analyses the trends in EPC, ��

Pratap Vijay Padode Editor-in-Chief, Infrastructure Today and Managing Director, ASAPP Media Information Group

Foreword

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Ernst & Young

Dear reader,

India’s EPC market has come under the global scanner. The sector has witnessed consistent changes over the past few years, with increasing project sizes, scale and market maturity. Riding on India’s �� INR40.9 trillion during the Twelfth Five Year Plan) the EPC sector is likely to make major advances. The order books of numerous players

are bulging, and the sector is attracting the increased interest of global majors, and Indian conglomerates as well as infrastructure developers.

The sector has become more dependent on infrastructure investments than ever before. This trend is further illustrated by the fact that projects awarded by the Indian Government are gradually shifting toward the Private Public Partnership (PPP) model. Some sectors, such as highways and power, have reached a mature stage, whereas others such as the railways and urban infrastructure are yet to develop through the PPP model. Today, EPC contractors have a healthy mix of government and private sector clients, as compared to their heavy dependence on government clients until few years ago. Therefore, companies have to adapt to such changing environments.

Over the past three years, some large EPC companies have seen a ~20% growth in their �� !�� "��#�� $�� &�� !�� '�� resource constraints (including that of skilled labor). In the present scenario, companies �� revenue growth.

Companies have been constantly exploring and innovating means of overcoming the challenges mentioned above. This report discusses the latest trends and the market direction, as well as the strategies adopted by various players to adapt to the ever �� *��'�� insightful.

Sushi Shyamal Partner, Transaction Advisory Services Transportation Infrastructure and Construction Sector Leader, Ernst & Young India

Heading 1

Engineering, Procurement and Construction (EPC)/3 �� 6


Understanding EPC��A decade ago, the EPC industry comprised a handful of large, complex projects and multitude small packages and subcontracts. Today, there is no dearth of high value and complex projects being executed by government and private players. The increasing size and complexity of projects has, however, led to a growing reliance on contractors’ capabilities and project management skills.

5�� contracts. Slowly but steadily, the onus of project management has shifted from the owner/developer to the contractor. Gradually, the risk of time and cost overruns has been transferred to the contractor, along with the responsibility of designing, procurement of materials and construction. Standard clauses and conditions prevailed, ��:;5�� !�� owner/developer and the contractor.

��There are several types of construction contracts that are used. While some are item ��<�� <�� !�� to the contractor. Some contracts include the client’s design requirements, but others �� =�� <�� >��<�� Contracts wherein the onus to deliver the facility for a guaranteed price within a �� <�� contractor are categorized as turnkey contracts. These are therefore awarded either on a package or turnkey basis or are a combination of the two.

Under the package-based model, time and cost overrun risks may lie with the owner or developer. Under the turnkey model, failure to comply with any of the requirements would necessarily have an adverse impact on the contractor. This model has gained popularity since it places the responsibility for designing, procurement and construction �� =�� '��completion time and costs, since it places the onus of successful project delivery on the contractor.

?�:;5�� are dependent on the contract model.

Introduction


Turnkey contract versus packaged-based contract

Criteria Turnkey contract Packaged-based contract

Price Guaranteed price for execution No guarantee on the price

Time Guaranteed timeline for completion No guarantee on the timeline

Procurement Undertaken solely by the contractor As per agreement between the two parties

Engineering/Design Responsibility of the contractor Responsibility of the owner/developer

Responsibility Contractor takes single point of responsibility 5��

Point of contact Contractor is single point of contact for all matters for the project developer

Owner/developer has to coordinate with several participants along with the contractors

Level of Involvement Contractor is free to work with limited supervision - ��

Owner/developer to undertake a day to day supervision of most of the activities

Risk =�� =�� H��

��The onus for successful project execution rests with various stakeholders with varying roles and responsibilities. In the initial stages, the project owner or developer appoints an in-house or external consultant to prepare the initial design and manage the tendering process. On the EPC contract being awarded, the contractor formulates a detailed design, and makes arrangements for procurement and execution, based on the approved design. The contractor may subcontract some �� $��<to-end execution process is overseen by the project management consultant (PMC), who monitors and ensures successful delivery of the project. Depending on the size and complexity of the project, the PMC may be an in-house team of the owner or developer, a contractor or a third party agency.

Role matrix

ConsultantGovernment/

owner/developer

Subcontractors

EPCcontract

Suppliers/vendorsContractor

PMC(Third party/in-house)

PMC(Third party/in-house)


Participant Role and responsibility Illustrative players

Owners/Developers J 3�� '�� and cost of project

J Supervises project work with in-house or external consultants

J Makes payment according to agreed upon milestones in contract

Public sector — NTPC, NHAI, AAI, Port Trusts

Private sector — Tata Power, Reliance Power, GMR Group, GVK Group, Adani Group, Sterlite, Essar Group, JSW, AVB Group

Consultants J Prepare initial design for tendering document

J Manages tendering process

EIL, Stup, Rites, Mott Macdonald, Halcrow, CES- Jacobs

Contractors J Prepare detailed design based on agreed upon ��

J Procures 3M resources (material, machinery and manpower)

J Delivers project according to the terms of the the contract

J [��<��

L&T, HCC, NCC, Punj Lloyd, IVRCL, Gammon, Patel Engg. Shapoorji Group, IRCON, Navyuga, Leighton, Isolux

Suppliers/Vendors J Supply materials/equipment required for execution of project

General Electric, Mitsubishi, Thermax, Hitachi, Alstom, BGR Energy Systems, BHEL, JCB, Eicher Group, Doosan Group

Sub-contractors J Deliver work to the contractor — typically a back-to-back contract with the contractor

Sadbhav, Ramky Infrastructure, Indu Projects, Coastal projects, ITD Cementation, Welspun Projects, Afcons, Soma

Project Management Consultants (PMCs)

J Supervise work undertaken by contractor and sub-contactor

J Ensure timely procurement and adequacy of resources

J Report progress and issues to owner/developer/contractor

Local contractors and consultants providing these services

��The Indian EPC sector, with its rising prominence and changing dynamics, has over 150 participants and a multitude of stakeholders (see Annexure attached) today. Players have carved out a niche for themselves and have developed their reputation, based on their sector focus. Some have also divested their operations in other sectors, thereby segregating the entire EPC space, based on operational segments.


Segment Illustrative domestic players Illustrative foreign players An insight

Infrastructure construction

L&T, HCC, Gammon, IVRCL Patel Engg., Era Infra, Simplex, Sadbhav, Nagarjuna

Isolux, ITD Cementation, IJM, Leighton, ACS, Hochtief, Vinci, SNC

Increasing opportunities in the infrastructure sector have attracted many new entrants to this space.

Building construction

L&T, Shapoorji Pallonji, Ahluwalia Contractors, BL Kashyap, BG Shirke, BE Billimoria, CCCL, Man Infra, Supreme, Shapoorji Pallonji EPC, Unity Infraprojects

Foreign participation —only in project management

The space is unorganized in nature and is dominated by many local contractors. Foreign players only operate as PMCs, architects and consultants.

Oil & Gas EPC L & T, Punj Lloyd, Petron, Essar Projects, Mc Nally Bharat

Aker Solutions, Leighton, Saipem, Bechtel

There is high competition from foreign participants, especially for offshore contracts.

Power EPC BHEL, Thermax, L&T, Tata Projects, KEC International, Kalpatru- JMC, Lanco Infratech, BGR Energy

Doosan, Dongfang, Siemens, Bechtel, Hitachi, Thermax, BHEL, Ansaldo

The space is dominated by equipment manufacturers, especially from South East Asia. Foreign players prefer to enter joint ventures (JVs) with India partners.

Specialized EPC Shriram EPC, Coastal Projects, Navayuga Afcons, Simplex, ECE

ABB, Uhde India, Toyo Engineering, Samsung Engg, Alstom, Mitsubishi, Mitsui

This space comprises players who have carved a niche for themselves in segments such as hydel tunneling, marine construction, power transmission, equipment supply or industrial construction.

India’s Planning Commission has announced infrastructure investments of INR40.9 trillion during the Twelfth Five Year Plan period, and the EPC sector, with its estimated �� >��"]^_`�_� �� investments. While the power and highways sectors are expected to continue being the Government’s main investment focus areas, the urban infrastructure and telecommunications sectors are also expected to witness enhanced investment.1

Tenth Plan Eleventh Plan Twelfth Plan

Planned investments INR 8.7 trillion INR 20.5 trillion INR 40.9 trillion

Actual Investments INR 9.6 trillion INR 16.5 trillion1 (E) -

EPC opportunity INR 4.5 trillion INR 9.5 trillion INR 17.1 trillion

Sectoral mix Power: 37%

Roads: 14%

Telecom: 11%

Railways: 11%

Irrigation: 13%

~50% spend on power and roads — above targeted achievement in power sector

Power: 32%

Roads: 14%

Telecom: 17%

Irrigation: 12%

Railways: 10%

Power and roads consistently amounting to ~50% of planned expenditure — added focus on telecom

Power: 31%

Roads: 12%

Telecom: 25%

Railways: 7%

Irrigation: 9%

Greater thrust on telecommunications — increased expenditure on ports, oil and gas pipelines

1 Pro-rated based on actual investments up to FY 09


The sector is not however without bottlenecks. There is an increasing realization among contractors to concentrate on their core competencies and prudently select projects . Furthermore, given a weakening global economy, there is a growing focus on growth �� '��range from regulatory bottlenecks, land acquisition issues to a resource crunch. These ��

As is the case with every challenge, there are also opportunities. Contractors implement varied strategies to adapt to changing sector scenarios. While many are gradually diversifying into the asset development business, others are seeking technical partnerships, especially with foreign players. While Indian players have taken the inorganic route to venture into international markets, global construction giants are attracted by India’s growth story. Funding, a critical factor on any construction platform, has been given the much-needed support required through PE investments. Lastly, as risks have increased, companies have developed organic project management teams to put in place and maintain standards, deliver successful projects on time and sustain ��

EPC is today highly dependent on the infrastructure sector in general and the PPP model in particular to overcome resource constraints and budgetary limitations. Furthermore, with government agencies gradually handing over asset ownership and development responsibilities to private parties, there is increasing reliance on the private sector for the growth of the EPC sector.


2


EPC — infrastructure interdependenceThe performance of the EPC sector is primarily interlinked with infrastructure investments. With infrastructure investments assuming a position of prime importance in the Indian economy, the EPC sector has also been demonstrating clear signs of positive growth. While :;5�� advent of new models has changed the clientele base for them — from government authorities to a mix of public and private clients. Proposed investments of INR40.9 trillion (an increase of ~ 100% over the Eleventh Five Year Plan) during the Twelfth Five Year Plan indicate that the EPC sector is set to demonstrate corresponding growth. During the Twelfth Five Year Plan period, the construction opportunity in the infrastructure sector is estimated to be around INR17.1 � ��|}�� :;5��

�� !"#!$!"#%'�

The opportunity pie

Segment wise break-up of investment planned in Twelfth Five Year Plan (INR billion)

Source: Indian Infrastructure, August 2011

4,900

4,5001,050

662

12,576

2,623

10,117

3,986

1,852 257

Road & Bridges Railways PortsAirports Power Oil & GasTelecom Irrigation Water supplyStorage

Sector Proposed total investment (2012–2017) (INR billion)

Construction Intensity (%)

Construction opportunity (INR billion)

Roads and Bridges 4,900 65 3,185

Railways 2,964 78 2,312

Ports 1,050 50 525

Airports 662 42 278

Power 12,576 38 4,780

Oil and gas pipelines 2,623 25 656

Telecom* 10,117 10 1012

Irrigation 3,986 75 2,989

Water supply and sanitation

1,852 66 1,222

Storage* 257 50 128

Total 40,992 - 17,087

*Construction intensity is assumed with comparison to buildings as per data available in the Planning Commission’s report. In the case of telecom, construction intensity of 10% has been assumed.


While the telecommunications sector is expected to account for ~25% of the planned infrastructure spend, there may not be a corresponding rise in pro rata growth in the EPC space. On the other hand, the power and highways sectors are expected to generate 47% of the expected INR17.1 trillion construction opportunity.

��India’s economy has been growing at a rapid pace, and to maintain the momentum of its growth, the Government has strengthened its focus on infrastructure development in the country. It has increased its infrastructure spend as a percentage of the country’s GDP from 5.15% during the Tenth Five Year Plan (2002–2007) to 7.55% during the Eleventh Five Year Plan (2007–2012)2. This is expected to increase to over 9.00% during the Twelfth Five Year Plan (2012–2017).3 According to the Planning Commission’s report, the Government plans to double its investment in infrastructure to INR40.9 trillion during the Twelfth Five Year Plan from INR20.5 trillion during the Eleventh Five Year Plan period, as compared to planned infrastructure investments of INR8.7 trillion during the Tenth Five Year Plan period. It should however be noted that actual investments during the Tenth Five Year Plan period had met the target4, and that of the Eleventh Plan period may realize 80% of the target.

2 “Mid-Term Appraisal-Eleventh Five Year Plan (2007-2012),” Planning Commission website, http://planningcommission.nic.in/, accessed 14 September 2011, p.293–295.

3 “Column: Target 9% growth. Riders aplenty,” Financial Express, 9 September 2011, via Factiva, © 2011 Indian Express Online Media Pvt. Ltd.

4 ”Economic Survey 2010-11,” Union budget and economic survey website, http:// indiabudget.nic.in/survey, accessed on 29 September 2011.

Comparison of segment-wise composition of infrastructure expenditure

0.0%

Pow

er

Road

s an

d br

idge

s

Tele

com

mun

icat

ions

Railw

ays

Irrig

atio

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Wat

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uppl

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nita

tion

Port

s

Airp

orts

Stor

age

Oil

and

gas

pipe

lines

10.0%

20.0%

30.0%

40.0% 37.0

%

13.8

%

11.1

%

11.1

%16.8

%24

.7%

13.0

%

6.5%

2.5%

2.0%

2.6%

0.8% 3.

5%

0.6%

0.6%

0.4%

6.2% 6.4%

1.8%

1.6%5.

4%4.

5%

12.0

%

9.7%9.8%

%7.

2%%13

.6%

12.0

%

32.1

%30

.7%

Tenth Five Year Plan (actual investments) [INR 9.1 tn] Eleventh Five Year Plan (revised projections) [INR 20.5 tn]Twelfth Five Year Plan [INR 40.9 tn]

Source: Planning commission

As the infrastructure space grows in size, we have observed two trends. First, as the size of projects tendered for are increasing, the projects themselves are becoming grander and more complex. Concomitantly, we are also seeing greater competition: the infrastructure pie is being split- up, though the extent of the competition varies by sector. These trends portend interesting times ahead.

Sushi Shyamal, Partner, Transaction Advisory Services, Transportation Infrastructure and Construction Sector Leader, Ernst & Young India


The telecom sector has been witnessing increasing investment over the past 10 years. During the Twelfth Plan period, almost 25% of investments are expected to be invested in this sector. *�� !�� is expected to witness a CAGR of ~10% from 2002 to 2017. Another sector, which has gained increasing prominence is the oil and gas segment — with the Government’s spend on the sector expected to increase from 3.5% of its total infrastructure spend during the Tenth Plan to 6.4% in the Twelfth Plan.

(��)��scenario *��5

India has the world’s second-largest road network, comprising a total length of 4.2 million km, �� `�}�� $��the Twelfth Five Year Plan is estimated to be INR4.9 trillion. Construction intensity in roads and bridges is projected to be around 65%, which is likely to result in construction opportunities worth INR3.185 trillion during the Plan period.

The National Highway Development Programme (NHDP) has planned expenditure of INR2.5 trillion. It seeks to award 29,000 km of roads from FY2011 to FY 2015 — out of this, 7,300 km. are expected to be awarded in FY12. (Around 70% of such awards are expected to be under the PPP mode.) Till August 2011, 247 PPP projects were awarded under NHDP. Planned NHAI project awards for 7300 kms. (worth INR5 trillion) would result into investments over FY2013–FY2016.

During the Twelfth Five Year Plan period, around INR3.6 trillion of investments are expected from the private sector, out of which INR2.5 trillion is likely to be awarded through NHDP projects and the balance through state project awards. Public spending is projected to be predominantly through award of contracts by state governments and strengthening of the rural road network.

5 Ministry of Road Transport and Highways 2010–11 annual report; Source: “Sector focus: infrastructure data,” Indian Infrastructure, August 2011. Pg. 174; India Infrastructure - PPP Opportunity, May 11, Ernst & Young publications.

Investments in roads and highways (INR billion)

Planned

Public

Private


Source: “Sector focus: railways,” Indian Infrastructure, August 2011Planned investment: “Investment in Infrastructure during the Eleventh Five Year Plan,” The Secretariat for Infrastructure, Planning Commission, www.infrastructure.gov.inPrivate and public share: Investment in Infrastructure during the Eleventh Five Year Plan as published by the Secretariat for Infrastructure Sep 2010

0

1000

2000

3000

4000

5000

6000


*��6

Indian Railways (IR) network spans over 64,000 route km, making it the world’s third-largest rail network in terms of size besides being the largest passenger carrier and the fourth-largest rail freight carrier globally. In the Twelfth Five Year Plan total investment is estimated to be INR29 billion. Construction intensity in railways is around 78%, which will result in opportunities worth INR23 billion during Twelfth Five Year Plan.

Rail projects in India have been typically the domain of the public sector. However, based on the success of PPP in other infrastructure sectors, the Indian Railways (IR) has begun to take steps to explore the PPP route. Mass Rapid Transit System (MRTS) is expected to comprise a major portion of total planned investments in coming years. During the Twelfth Plan period, private sector spending is expected in MRTS systems in cities such as Mumbai, Bengaluru, Hyderabad and Kolkata. The IR is also expected ��;;;� �'�� "��stations across India that will be modernized into world- class facilities7.

=�� corridors are yet to be unbundled by the IR and may be explored on the PPP mode to change the public-private spending mix.

Ports8

India has 13 major ports and around 200 non-major ports, accounting for 95% of the country’s total trade in terms of volume, and around 70% in terms of value. During ��__�� "�� 5?�^��`�� }��`million tons to 883 million tons. In the Twelfth Five Year Plan, total investment is estimated to be INR1050 billion. Construction intensity in ports is around 50%, which is expected to result in a construction opportunity worth INR525 billion during the

6 “Indian Infrastructure-Sector report,” Religare, 24 June 2010, via Thomson Research; India Infrastructure - PPP Opportunity, May 11, EY Publications.

7 http://www.livemint.com/2008/01/03231547/Tatas-Ambanis-DLF-interested.html8 “Sector focus: ports and shipping,” Indian Infrastructure, August 2011; The Indian ports and

shipping sector: realizing potential, EY Publications, August 2011

Investments in railways (INR billion)

Planned

Public

Private


Source: “Sector focus: railways,” Indian Infrastructure, August 2011Planned investment: “Investment in Infrastructure during the Eleventh Five Year Plan,” The Secretariat for Infrastructure, Planning Commission, www.infrastructure.gov.inPrivate and public share: Investment in Infrastructure during the Eleventh Five Year Plan as published by the Secretariat for Infrastructure Sep 2010

0

500

1000

1500

2000

2500

3000

3500


Twelfth Plan period. The National Maritime Development Programme seeks to add 230 million tonnes per annum in capacity in 10 years. To achieve this, the Ministry of Shipping (MoS) plans to award 24 capacity-expansion projects at major ports, entailing an investment of INR170 billion, by FY12. These projects include a mega container terminal at Chennai port (INR37 billion) and a mechanized berth at Vishakhapatnam (INR2 billion). However, the only project that has been awarded so far is the Jawaharlal Nehru Port Trust Terminal 49. This is likely to accelerate the process of privatization and port development. The outlook is therefore optimistic for the overall ports sector.

Airports#"

India has a total of 136 airports with 94 owned by the Airport Authority of India. During ��`��__�� "�� 5?�^��10.44% and 10.93%, respectively, despite the global slowdown. Total investment is estimated to be INR662 billion in the Twelfth Five Year Plan. Construction intensity in airports is around 42%, which is expected to result in construction opportunity worth INR278 billion. With prospects for growth in tier II and III cities looking bright, the [�� 5��?��[�5?�� "]^��$��]��[�� airport in terms of cost and capacity and is expected to be bid out this year. The nodal ��5"35�� >�� of such large projects continues to be a concern. Over time, institutionalization of a transparent and competitive bidding process is the only way to decide the fate of such large projects. Infrastructure linkages are also immensely important, since provision of adequate road, rail and water transport facilities will be critical for the success of large -scale airport development plans (such as the one planned in the Navi Mumbai area).

9 “Defence Ministry told to speed up port project clearance” The Economic Times, 7 October 2011.

10 “Sector focus: airports and airlines,” Indian Infrastructure, November 2010; India Infrastructure - PPP opportunity, May 11, Ernst & Young publications; “Sector focus: civil aviation,” Indian Infrastructure, August 2011.

Investments in ports (INR billion)

0

1000

Planned

Public

Private

1200

800

600

400

200


Source: “Indian Infrastructure-Sector report,” Religare, 24 June 2010, via Thomson Research; Planning Commission website Planned investment: “Investment in Infrastructure during the Eleventh Five Year Plan,” The Secretariat for Infrastructure, Planning Commission, www.infrastructure.gov.inPrivate and public share: Investment in Infrastructure during the Eleventh Five Year Plan as published by the Secretariat for Infrastructure Sep 2010


During the Twelfth Five Year Plan period, private sector participation is expected to rise to 65%. Major projects undertaken in the PPP format till now include that of the Hyderabad, Delhi, Bangalore and Mumbai airports. The Airports Authority of India is developing 18 new terminals at existing airports on an EPC basis.11

Power#!

India’s total installed power generation capacity (excluding its captive capacity) stood at 1,73,626 MW as of March 2011. Robust economic growth and enhanced industrial �� much as 12% peak hour power shortages. This makes a compelling case for further large scale investments in the sector. Between 2007 and 2010, 32,000 MW of generation capacity was added in the country. In the Twelfth Five Year Plan, total investment is estimated to be INR12,576 billion. Construction intensity in the power sector is around 38% at present and is expected to result in construction opportunity worth INR4,780 billion.

; �� with the announcement of 14 ultra mega power projects (UMPPs). Out of these, four (Sasan, Mundra, Krishna Patnam and Tilaiya ) have already been awarded to private players. What is most heartening about the power sector is the record growth in generation capacity addition and initiatives that have helped to create sound policies and regulatory frameworks, which have had a positive effect on promoting competition and investments in the sector.

11 ��/HH�� H��H��<��<��<�<_�<��<�� H_��`�H12 “Sector focus: power,” Indian Infrastructure, August 2011

Investments in airports (INR billion)

Planned

Public

Private

Tenth Plan Eleventh Plan Twelfth Plan0

100200300400500600700800900

Source: “Sector focus: civil aviation,” Indian Infrastructure, August 2011Planned investment: “Investment in Infrastructure during the Eleventh Five Year Plan,” The Secretariat for Infrastructure, Planning Commission, www.infrastructure.gov.inPrivate and public share: Investment in Infrastructure during the Eleventh Five Year Plan as published by the Secretariat for Infrastructure Sep 2010


+��#,

India’s oil and gas sector continues to grow steadily, boosted by enhanced investments, �� "�� [[$;?�� `��[[$;?��petrochemicals capacity and 25.3 MMTPA of new LNG terminals. Total investment is estimated to be INR2,623 billion in the Twelfth Five Year Plan. Construction intensity in oil and gas is around 25%, which is expected to result in construction opportunities worth INR656 billion. Some of the major projects under way in the oil and gas segment ��_�[[$;? �� "��5� �� "]^��}billion) and a cracker unit of 5 MMTPA capacity by Reliance Industries Limited (RIL) in Jamnagar, which is estimated at INR158 billion.

13 “Mid-term Appraisal — Eleventh Five Year Plan (2007–2012),” Planning Commission website

Investments in power (INR billion)

Planned

Public

Private


2000

4000

6000

8000

10000

12000

14000

Source: “Sector focus: power,” Indian Infrastructure, August 2011; “Indian Infrastructure-Sector report,” Religare, 24 June 2010, via Thomson ResearchPlanned investment: “Investment in Infrastructure during the Eleventh Five Year Plan,” The Secretariat for Infrastructure, Planning Commission, www.infrastructure.gov.in Private and public share: Investment in Infrastructure during the Eleventh Five Year Plan as published by the Secretariat for Infrastructure Sep 2010

Investments in oil and gas (INR billion)

Planned

Public

Private


500

1000

1500

2000

2500

3000

Source: “Sector focus: oil and gas,” Indian Infrastructure, August 2011Planned investment: “Investment in Infrastructure during the Eleventh Five Year Plan,” The Secretariat for Infrastructure, Planning Commission, www.infrastructure.gov.in Private and public share: Investment in Infrastructure during the Eleventh Five Year Plan as published by the Secretariat for Infrastructure Sep 2010


-�.��#/�

India is witnessing a sharp change in its demographic composition. Factors including rapid economic growth and migration of the rural population to urban areas is leading to a never before seen growth in urbanization levels. Both government and independent �� '�� >��to lead to a structural shift in the Indian economy, which is likely to transition from primarily being an agrarian economy to a more service and manufacture-driven one.

Increased urbanization is expected to lead to the emergence of more megacities and bigger population clusters, which is likely to have a positive effect on the number of :;5� �'�� $�� '�� portion of the rural population, who migrate in search of job opportunities. Given the �� !��people at a time of economic growth is likely to lead several of these cities emerging as mega cities in coming years.

The importance of urban infrastructure as a component of India’s infrastructure story can be gauged from the fact that by 2030, Indian cities are expected to contribute up to 70% of the country’s GDP and around 85% of its taxes. This poses both a challenge and an opportunity. The magnitude of the challenge can be understood from the fact that our urban areas may be required to accommodate an additional 250–300 million people in about two decades. These areas are already facing severe infrastructure constraints and this situation will only get worse if remedial action is not taken. Cities such as Mumbai and Delhi are cracking under the population pressure being exerted on them, which is leading to abysmally low levels of basic infrastructure facilities for water, sanitation, transportation, etc. The opportunity, however, lies in the fact that the Government estimates that its urban infrastructure investments will be around INR40 trillion over the next two decades.

14 “Sector focus: urban infrastructure,” Indian Infrastructure, August 2011

Source: Report on urban infrastructure and services by the high powered expert committee from national institute of urban affairs

Urban infrastructure investment requirement: 2012-31 (INR billion)

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��!�� ]�� ]�� Renewal Mission (JNNURM) are estimated to involve investments of about INR605 billion, which translates to around INR400 billion worth of EPC works15. Under the JNNURM, a total of 533 projects have already been sanctioned as of June 2011. The Twelfth Five Year Plan envisages an investment of INR1.8 trillion on water supply ��"]^_� �� "]^_� �� !�� INR1 trillion on urban transport facilities including MRTS/ BRTS/monorails and water transport facilities.

Sector No of projects

Drainage/Stormwater drainage 70

Roads/Flyovers 97

Water supply 147

Sewerage 108

Urban renewal 11

Mass Rapid Transport System 21

Other urban 15

Solid waste management 41

Development of heritage areas 6

Preservation of water bodies 4

Parking 5

Others 8

Total 533

Out of the total 533 projects, 27.5% are water supply projects, 20.2% sewerage � �'��_�� !�� '��_��_�� `�`��solid waste management. Among the states, Maharashtra has the maximum number of projects (78), which comprise 14.6% of the total 533 projects.

In terms of absolute spending, water, sewerage, and roads and transportation have taken up almost 84% of the funds spent under JNNURM.

15 Assuming construction intensity of 66% - based on construction intensity of water supply and irrigation


JNNURM Spending by sector for UIG and UIDSSMT

Water supply

41%

19%

24%

12%

3% 1%

SewerageRoads andtransport

Drainage

Solid wastemanagement Urban renewal


Around 41% of the funds have been expended on water supply, and going forward, ��'�� <�� The need for reliable water infrastructure is accentuated by the fact that no Indian city can claim to have 24x7 water supply — many continue to get water for only a couple of hours every day, and sometimes, the quality of water is questionable. On a positive note, authorities have now noticed these issues and we are witnessing �� =�� management and mass housing are urban sub-sectors, which are seeing traction by way of government and private investment. Encouragingly, construction intensity is one of the highest (at 66%) for urban infrastructure projects.

A look at the ranking of states in terms of urbanization levels points to geographies where an opportunity exits. The majority of JNNURM projects are awarded in heavily urbanized states such as Tamil Nadu, Maharashtra, Gujarat, Andhra Pradesh and Karnataka, which are facing severe infrastructure pressures due of urbanization.

In the case of projects relating to water supply, transportation, sewerage, etc., the bulk ��:;5�� business opportunities exist in the urban infrastructure space.

$�� ! �� '�� space has caught the attention of the private sector and has led to many companies queuing up to take up such projects. Specialized companies are emerging that have capabilities in urban infrastructure, and value is getting created for all stakeholders. However, we have not even scratched the surface as far as plugging the infrastructure gap that currently exists is concerned. Even if a fraction of the projected capital is spent on urban infrastructure, we will see an unparalleled business opportunity for the private sector, which will lead to the emergence of a new set of infrastructure “czars” in the private sector.


Urbanisation ranking: top 10 major states in India

0% 10% 20% 30% 40% 50% 60%

Kerala

Urban population

Madhya Pradesh

Andhra Pradesh

West Bengal

Haryana

Karnataka

Punjab

Gujarat

Maharashtra

Tamil Nadu

The infrastructure linked EPC sector is set for a big leap in India. We are expecting to see projects in roads and highways go on the fast track. While the MRTS is a step forward for the railways, unbundling of reforms are eagerly awaited. Also as the process of privatization has begun for ports, the sector shows positive prospects, as do the airports segment where Tier II and III cities are the focus of attention. The power sector is expected to see private players get a boost, while oil and gas see doubled investments in the XIIth plan. As our cities swell, urban infrastructure promises to be the story of the next decade.

Sushi Shyamal, Partner, Transaction Advisory Services, Transportation Infrastructure and Construction Sector Leader, Ernst & Young India


��.��.��.��0��Attractive PPP and EPC projects With the increasing need for accelerating infrastructure development to fuel India’s economic growth, there can be no doubt that the EPC sector is in an advantageous position. Sectors including roads, oil and gas, and power have relatively higher construction opportunities since these segments have reached a relatively mature stage. On the other hand, sectors such as urban infrastructure, particularly water supply, waste management and urban transport system, are gradually gathering steam.

Model shift for EPC players

EPC market dependency Sub-sector Clientele base* (government-private ratio)

Order of models adopted by Government

Infrastructure construction Roads 50: 50 PPP -> Annuity -> EPC

Railways 80: 20 EPC -> PPP

Ports 50: 50 PPP -> EPC

Airports 50:50 EPC -> PPP

Urban infrastructure 80: 20 EPC -> limited PPP

Building construction Building construction 20: 80 Cash contracts -> EPC

Oil & gas EPC Oil & gas 80: 20 EPC

Power EPC Power 20: 80 EPC

Specialized EPC Marine 20: 80 EPC

Hydro 80: 20 EPC

Industrial 20: 80 EPC

Source: Ernst & Young analysis * Assumption

The Government is expected to continue awarding projects in the EPC and PPP formats. However, in the PPP model, project owners or developers ultimately award work as EPC or other forms of contracts to either their own contracting entities on an arms- length �� ?�:;5�� through contracts awarded by government clients and private developers. As the PPP model gains popularity, there is likely to be a higher dependence on the private sector for contracts being awarded. Contractors are increasingly opting to convert themselves from executors to developers and risk takers due to the Government’s preference for awarding models on an ownership basis.

The Government has chosen to adopt various models to award contracts and for execution of projects. It is evident that the PPP mode is gaining prominence in infrastructure development. This has resulted in huge opportunities for EPC contractors. The private sector is driving this growth opportunity by investing equity in such PPP infrastructure projects. With its clear focus on undertaking and encouraging infrastructure development in the country, the Government is giving high preference to the PPP model. This has led to the entry of an increasing number of private players in �� private participant is eager to tap this opportunity.


Modes of project award

Criteria EPC PPP

Ownership Government Private

Model Contract Concession

$�� "�� cost overrun – especially due to external risks such as land acquisition, regulatory approvals

Accumulating interest costs, stringent contractual penalties, delay in revenue generation force a private operator under a PPP contract to complete project development within schedule and budget.

:�� Contractor job stops after construction and handover of the facility

; �� may dent its revenue, hence the facility is made more ��

Returns Based on project margins Returns on equity investments

Upsides None Project may deliver upsides

Project risk Only execution risk On the private player

Market risk Contractor’s revenue is dependent only on the construction of the facility

The revenue of the private player is generally dependent on the smooth running of the project

Operation and Maintenance Contractor is only responsible for constructing the facility

Private partner is responsible for operation and maintenance of the facility

Ernst & Young analysis

��1��Projects being awarded in the PPP mode have gained in popularity because they minimize �� !��$�� from traditional EPC contractors to Indian business conglomerates.

Furthermore, the increasing number of private sector clients have given rise to negotiated contracts as compared to the traditional competitive bidding format. The rise in such clients is expected to improve payment mechanisms and the working capital cycles of EPC contractors.

Private sector participation in Indian infrastructure projects was around 25% in the Tenth Five Year Plan (2002–2007), which increased to 36% in the Eleventh Five Year Plan (2007–2012) and is expected to increase further to around 50% in the Twelfth Five Year Plan (2012–2017). This translates into an increase from INR2.3 trillion in Tenth Five Year Plan to INR20.5 trillion in Twelfth Five Year Plan. With such rapidly growing opportunities, there has been a substantial rise in the number of new entrants in the sector.

Government

EPC contractor(owns asset)

SPV (operates and

maintains asset)

Government

EPC contractor

Contract execution

EPC contract award

EPC contract award

PPP contract award

Contract execution


��The fact that the sector has witnessed the recent entry of global construction giants, Indian business conglomerates and infrastructure developers, who are now competing with a host of EPC players, amply demonstrates the growth potential of the sector. Thus, a space that was earlier dominated by large EPC players and a few infrastructure developers, is now witnessing multiple participants, each set on carving out a piece of the EPC pie.

Infrastructure Developers

Construction Companies

Foreign Participants Financial Investors Business Conglomerates

Genesis J Presence across various facets e.g. power, highways, airport etc

J Entry into EPC as a means of backward integrations

J 2-3 decades of presence in the EPC business

J Participation in PPP projects to gain captive EPC contracts

J Preference to award PPP -> Annuity -> EPC contracts by government

J Established global concessionaires in European / Asian markets

J Interest in India as high growth market

J Degrowth in their local markets

J Domestic and local infrastructure funds/ institutions

J Participation in the sector as an infrastructure investment strategy

J Cash rich industrial groups

J Participation in the infrastructure sector due to its high growth and captive EPC businesses

J Entry strategy through M&A

Illustrative Players GMR, IRB, Lanco, GVK

L&T, HCC, IVRCL, Gammon, KMC, Madhucon, NCC, Soma, Patel Engg, Sadbhav

IJM, Isolux, Hochtief, Vinci, Atlantia, Leighton, Balfour Beatty, Plus Expressway

SREI, IDFC, SBI-Macquarie, ITNL, L&T Infra

Tata, Reliance Group, Welspun, Essar, JSW, AVB, Adani Group

Strategy Long term asset play across infrastructure sectors

EPC participation and asset development for captive EPC

India entry strategy – through available opportunities

Investors with high sector expertise becoming joint developers

Late entrants, preferring inorganic growth route

EPC Execution Capabilities

In-house capabilities or third party

In-house In-house and sub-contracting of low value works

Third party or JV partner

In-house capabilities or third party

Ernst & Young analysis

Source: Planning commission; Indian Infrastructure, August 2011

Infrastructure investments (INR trillion)

6.8

13.1

20.5

2.37.4

20.5

9.1

20.5

41.0

25%

36%

50%

0%

10%

20%

30%

40%

50%

60%

0.0

10.0

20.0

30.0

40.0

50.0

Tenth Five Year Plan (actual)

Eleventh Five Year Plan (planned)

Twelfth Five Year Plan (planned)

INR

trill

ion

Public Private Total Private (% of total investment)


EPC Market Sub-Sector Competition Complexity Government Role (Facilitator)

Entry Barriers

Opportunity Size

Foreign players interest

Current Status

Infrastructure Construction

Roads � X X X � � �Railways X X ± X X X X Ports ± � � � ± � ± Airports X � ± � ± � �Urban Infrastructure ± � ± X � ± �

Building Construction

Building � X X X � X X

Oil & Gas EPC Oil & Gas X � � ± X � ± Power EPC Power � X X X � � �Specialized EPC Marine X � � ± ± ± ±

Hydro X � � ± ± ± ± Industrial ± ± X X � ± �

Ernst & Young analysisHigh Low Medium

� ± X

Sectors such as roads, airports, power and urban infrastructure are very attractive for investors in Indian markets. This may be due to relatively low entry barriers in these markets, a strong project pipeline or the huge opportunity size. These sectors are also attracting the interest of foreign players. On the other hand, sectors such as the railways and buildings are relatively lower on the attractiveness scale — the railways await unbundling and buildings the recovery of the real estate sector.

As a result, the market as a whole has become a mixed bag of opportunities in which a variety of players are participating. Some have transformed themselves in order to adapt to the ever changing needs of the market; others have chosen the inorganic route to tap its growth potential. However, with opportunity comes associated business risks, and it is the ability of players to identify such risks and challenges that will help to sustain this dynamic market.

27Engineering, Procurement and Construction (EPC)/3 ��


Heading 3



Heading

Opportunities are often accompanied by challenges, and challenges are best overcome by mitigating associated risks. Today, the EPC market is serviced by several large, medium and small players, each looking to outperform its peers and grab a larger share �� <�� 5?�^��over 20%, it is essential for these players to take a sound and informative decision before bidding for EPC projects. Land acquisition delays, regulatory bottlenecks, competitive bids, working capital management glitches, etc., can lead to time and cost overruns and have an adverse impact on perceived project margins.

Some key aspects of these factors have been highlighted below:

��2�� When opportunities are aplenty and competition is intense, project selection becomes �� ^��indicate that if they are not selected judiciously, projects may drain resources without providing commensurate returns. Therefore, not only does improper project selection ��*��some delays are due to regulatory hurdles, others are caused by force majeure factors.

A careful examination of a project prior to bidding is essential to mitigate any unexpected future developments. A well- informed project selection team with adequate market intelligence to scrutinize every project before expending resources on detailed investigations is crucial. While most companies focus on creating healthy order books, it is also important for them to ensure the quality of these.

However, pre-tendering project selection is not the only challenge in a project. A well-selected project is still subject to execution risks. Therefore, the role of an effective risk management team has become more important than ever before due to its ability to foresee, assess and mitigate risks. While some uncertainties and risks are beyond the control of contractors and cannot be mitigated, these may be avoided through effective planning and establishment of a contingency plan.

Key business challenges


Source: Ernst & Young analysis

Key risks in an EPC contract

Political stability of the country; change in governments

"�� technology requirement leading to inaccurate time and cost estimations

3�� land acquisition –

Pre-tender stage Post-bid stage Execution stage

5��

Unfamiliarity with the local laws and regulations

Political risks

Environmental risks

Technical risks

Financial risks

Contractual/legal risks

Force majeure risks

Liquidity and credit shortage

Unfavorable climatic condition ��

:�� –

–

�� Hterrain; resettlement and rehabilitation; utility shifting

Foreign exchange and interest ��!��

Economic downturn 3�� unavailability of resources

Unfamiliarity with the local laws and regulations Limited say in contract negotiations

Unfamiliarity with the local ��

3��H��Resource availability; site conditions

Stage of EPC contract

4��7��0��.��.��9��drive growth Construction companies have demonstrated a weak performance at the bourses. While the BSE SENSEX has yielded a 19% positive movement over FY05–FY11, the market cap of construction companies has declined by 5% to 27% over the same period. This can be partly attributed to the global economic downturn, but it is also due to the diminishing � �� 16, construction companies can be broadly categorized into three categories: large (revenue > INR20 billion), mid (INR20 billion > revenue > INR10 billion) and small (revenue < INR10 billion). When their performance is studied through this categorization, a clear pattern emerges.

16 For our analysis we have included following construction companies: large sized — HCC Ltd, Gammon India Ltd, IVRCL Ltd, Larsen &Turbo, NCC Ltd, Simplex Infra, Patel Engineering , Era Infra; Mid-Consolidated Construction Consortium Lt, Jyoti Structures Ltd, Ahluwalia Contracts (India) Ltd, SPML Infra Ltd, ITD Cementation India Ltd, JMC Projects (India) Ltd, Sadbhav Engineering Ltd, Pratibha Industries Ltd; Small-KNR Constructions Ltd, J Kumar Infraprojects Ltd, Supreme Infrastructure India Ltd, Tantia Constructions and Welspun Projects.


4��9��Large companies have been hit less hard than smaller companies, because their advantage of economies of scale seem to have acted in their favor. The blow of losses � �� '�� capitalization (mcap) declined across all categories of companies, the mcap of large companies declined by 5% over FY05–11. Mid- and small-sized companies were not so lucky — the mcap of mid- sized companies declined by a staggering 20 % and those of small- sized companies by 27 % during the same period.

Things were much brighter for the industry between FY05- 08. Driven by economic growth and high infrastructure spending, construction companies registered high � �� >��<��trading at a P/E multiple of 29.7 in FY07, while mid and small companies traded at multiples of 19.1 and 12.1, respectively.

The track became slippery once the recession set in — while revenue growth was still strong due to order book positions (with revenue growth of 22%, 20% and 41% in large, ��<�� reduced valuations. Large companies were trading at a P/E multiple of 6.5 and mid and small companies at multiples of 4.6 and 2.7, respectively, in FY09.

Market performance of companies

Source: Bombay Stock Exchange (BSE)

0100200300400500600

Mcap (Large)

Sensex

Mcap (Mid)

Mcap (Small)

FY 0

5

FY 0

6

FY 0

7

FY 0

8

FY 0

9

FY 1

0

FY 1

1

Large companies: movement in valuation multiples

Source: Company annual reports; BSE

0.0

0.5

1.0

1.5

2.0

2.5

0

20

40

60

FY05 FY06 FY07 FY08 FY09 FY10 FY11

EV/EBITDA P/E Market Cap/Sales (secondary axis)


Today, while companies have recovered from FY09 levels, they are still trading at huge discounts. Current trading P/E multiples for large, mid and small-sized companies are in the range of 14.0, 12.8 and 4.3, respectively. It has been observed that small-sized companies are under the maximum stress in current market conditions.

*��0��.��Construction majors have seen mixed fortunes since FY05. While their growth was strong until the onset of the recession, the period from FY08 onwards saw a drop in �� >��?��slowdown lasts, it is prudent for construction companies to preserve their capital by �� '��are competent to execute.

Mid companies: movement in valuation multiples



0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

0

20

40

60


Small companies: movement in valuation multiples



0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

0

20

40

60



$�� &��;?$�� <��>�� }�� <�� _�_�� =�� __��}�_�� <�� CAGR (+4%, +8% and -19%, respectively).

�� __�/

J Revenue — ~20% growth over FY08-FY11 While this is not comparable to the growth over FY05–FY08, revenue performance over the past three years has been robust.

J :�"$3?�� &|_�� [��<��>�� pressure on their EBITDA margins.

J Interest and depreciation costs — Increased across all category of companies, ��

J PAT margins — Declined to 3%-4% across all companies

J Order books — Remained robust and increased at a CAGR of around 20% - 35%

$�� &�� !��< �� clients, inability to receive design in time and scope change approvals from clients include only some of them. All these factors, however, adversely impact project cash !�� $�� shareholder returns.

Between FY08 and FY11, companies have been adversely impacted by the slowdown in project awards, execution hurdles and rising interest rates. This has resulted in stretched working capital and has led to an increased debt burden on the balance sheet. With valuations increasingly being driven by earnings rather than by the order book, �� $�� shift from top-line growth to bottom-line recovery today.

Unit FY05 FY08 FY11

Large-sized companies

EBITDA margins % of revenue 10.3% 13.5% 13.1%

Interest % of revenue 2.8% 3.6% 5.5%

Depreciation % of revenue 1.6% 1.6% 1.9%

PAT margins % of revenue 4.9% 5.9% 3.8%

Mid-sized companies





;��<��=��






Growth comparison for large companies

Source: Company annual reports

46.6%

57.1%

40.0%

21.6%

4.7%

22.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Revenue growth PAT growth Order book growth

FY 05-FY 08 FY 08-FY 11

Growth comparison for medium companies


FY 05-FY 08 FY 08-FY 11


64.4%

130.2%

41.0%

19.4%7.9%

35.0%

0.0%20.0%40.0%60.0%80.0%

100.0%120.0%140.0%

Growth comparison for small companies


FY 05-FY 08 FY 08-FY 11

105.6%

184.4%

35.0%40.7%

-19.3%

20.0%

-50.0%

0.0%

50.0%

100.0%

150.0%

200.0%



>�� cost overrunsIt is a belief that most construction projects have to face the risk of time and cost overruns — statistics back this belief. As on February 2011, out of a total of 559 ongoing infrastructure projects in India, 293 were delayed. Out of the delayed projects, 69 were a month to a year behind schedule, while 67 projects were delayed by 13–24 months, 107 by 25-60 months and 37 by over 60 months.

*��!�� "��effective cost escalation. The 293 delayed projects have added an incremental cost of INR682.7 billion, amounting to a 22.3% escalation. The highway sector has seen the maximum number of delayed projects, predominantly due to land acquisition and Right of Way issues. Other key sectors plagued by cost overruns are the petroleum, power and the railways.

Cost overrun in various segments17

17 “293 delayed projects led to cost overrun of Rs 68K crore,” Realty Plus, 23 February 2011, via Factiva, © 2011 Adsert Web Solutions Pvt. Ltd.

Project status of 559 infrastructure projects

Source: “Infrastructure data,” India Infrastructure, August 2011

22%

2%

15%

52%

DelayedOn scheduleAhead of schedule]��

Sector Number of projects delayed

Delay period (months)

Cost overrun (INR billion)

Roads and transport 111 1 – 90 NA

Power 41 1 – 83 45 (4%)

Oil & gas 33 1 – 74 181 (45%)

Railways 25 3 – 225 NA

Urban infrastructure 2 NA 154 (102%)

Coal 18 8 – 64 22 (16%)

Other 63 - -


Some key issues and their impact of delay in time and cost overruns:

Some recent cases of EPC projects getting delayed or experiencing cost overruns181920212223242526

18 ¡[�� _��/[[^3?¢�Hindustan Times, 5 September 2011, via Factiva, © 2011. HT Media Ltd .19 “Seven Years Later, it is Nonstarter”, NBM & CW, 1 May 2010, via Factiva, © 2010. NBM Media.20 “New Mumbai bridge to open after a decade of delay as India struggles to improve infrastructure”, Associated Press Newswires, 30 June

2009 via Factiva, © 2009 The Associated Press.21 “Work On Worli-Haji Ali Sea Link Not Starting On July 3,” The Times of India, 2 July 2011, via Factiva © 2011 The Times of India Group.22 “Coal glitches will delay Chhattisgarh UMPP bids,” DNA, 1 May 2010, via Factiva, © 2010. Diligent Media Corporation Ltd.23 “Chennai Metro awaits Cabinet nod,” The Economic Times, 21 December 2008, via Factiva, © 2008 The Times of India Group24 “Chennai metro project cost likely to rise 23%,”, Business Standard, 29 September 2010, http://www.business-standard.com/india/news/

chennai-metro-project-cost-likely-to-rise-23/409557/ (not found in Factiva).25 “Fresh hurdles may further delay Polavaram project,” The Hindu, 31 May 2010, via Factiva (c) 2010 Kasturi & Sons Ltd .26 “Polavaram project cost escalates,’ The Hindu, 19 November 2009, via Factiva, (c) 2009 Kasturi & Sons Ltd.

Issue Impact on time Impact on cost

Ambiguity in design and engineering ��

Delay in arrival of detailed drawings by consultant

_

Land acquisition challenges Delay in project completion :�� '��!��

Delay in procurement and delivery of critical equipment

Impacts several activities, depending on the need for equipment in the critical path

Overall increase in project cost due to idle time of several resources

Shortage of construction materials Delay in dependent activities impacting subsequent activities as well

Overall increase in project cost due to idle time of several resources

Change of scope Impacts overall project time line and resource utilization

Impacts cost and working capital cycles due to the extra work

Lack of coordination between various participants (vendors, sub-contractors, etc)

Idle time of several resources Extra cost incurred due to lower productivity and increased idleness

Delay in regulatory clearance 3� �� '�� :�� '��!�� <��

"�� '��contingency funds

_ Cost of project deviates from budget with high variation

Rise in the cost of raw materials _ Impacts margins as cost escalation clause may only cover some of the costs

Delay in payments by the owner [�� '��gap created by the delay in payments

Contractor may have to raise funds through additional equity or debt to fund working capital

Project Reason for delay Cost or time escalationMumbai Metro 119 Execution challenges in most crowded areas Anticipated one year delayKalindi Kunj by-pass project20 Project awaiting land approval from UP

governmentTime delay of seven years and cost escalation

Bandra-Worli sea link project21 Midway design adjustments along with issues related to environmental clearance and public interest litigations

$��

Worli – Haji Ali project22 State government requesting change in original design and scope

No estimates released as of now

Ultra Mega Power Project (UMPP)23 Chhattisgarh UMPP delayed due to unavailability of coal linkages

Project yet to take off

Chennai Metro Rail24 Lack of consensus between Planning Commission and Urban Development Ministry about the project partners

Project cost likely to increase by 23%25

Polavaram Project in Andhra Pradesh26 Clearances from The Central Electricity Authority (CEA) and The Expenditure & Finance Committee (EFC) of the Ministry of Finance due

5��INR13.3 billion27


Some factors such as land acquisition and environmental clearances may be beyond the � �� #�� '��many controllable risks. As increasing cost escalations and project delays become a reality in today’s infrastructure and construction space, contractors have realized the need for strong project management frameworks.

,4��)��?�� A booming economy, large construction opportunities and bulging executable order �� <��<��!�� "��imperative for Indian EPC players to overcome execution challenges faced due to �� $�� ?�� &quality, delivery and costs.

;��The Indian construction sector has organized manpower of nearly 1.2 million and unorganized manpower of over 30 million.27 However, alternative opportunities such as in the IT sector, government guaranteed job schemes for villagers and emergence of opportunities in other emerging sectors has or can potentially lure away much of the workforce.

Almost simultaneously, the exponential growth in the sector has generated a labor crunch, thereby increasing the demand for the existing workforce. A construction association’s interaction with construction industry participants reveals that construction projects are getting delayed due to around 40% shortage of skilled construction workers.28

Based on India’s economic growth and the sector’s opportunity potential, it is estimated that about 58.3 million people will be employed in the sector by 2022.29 The Indian Government has implemented its National Commission of Skill Development program to create human capital for various sectors including construction in response of the country’s need for skilled labor.30

��The magnitude of upcoming infrastructure projects in the country – currently under �� &�� such as cement, coal and steel. In recent years, global markets have seen abrupt !�� based on price movements and procurement strategies. For instance, cement prices had peaked at INR4,920/ ton in FY 10 — an astounding 60% increase from FY05 � ��=�� "]^}}�``}�� increase of 50% from FY05 prices. As discussed earlier, there are various EPC contracts, and depending on escalations built into contracts, contractors have either absorbed

27 “Construction Sector,” Centrum Research, 30 August 2010, via Thomson Research28 “Labour shortage proves a challenge in Gujarat,” Business Line (The Hindu), 18September

2011, via Factiva, (c) 2011 The Hindu Business Line.29 ‘Construction industry facing manpower crunch’,” Business Line (The Hindu),3 May 2011,

via Factiva, © 2011 The Hindu Business Line.30 “Construction Sector,” Centrum Research, 30 August 2010, via Thomson Research.


these variations or been insulated from such movements. The key takeaway from this phenomenon is the necessity to factor in all anticipated variations while ensuring cost competitiveness to win orders.

��0��With many Indian companies winning high-value and complex projects, it has been observed that there has been a concomitant increase in their preference to be owners of equipment as compared to the hire model. Evidence substantiates this fact through increasing depreciation costs over the years. It is also essential for companies to maintain a prudent mix of owned and leased assets and work on healthy asset turnover ratios.31 Moreover, they need to realize that when they procure and own an asset base ��>�� <��'�� $�� <going utilization and cost impacts.

31 ?��$ �� ^��/�� H� �� base owned by a company

Cement prices (INR per tonne)

Source: CRISIL Researc

-

1,000

2,000

3,000

4,000

5,000

6,000


Steel prices (INR per tonne)

Source: CMIE

-

10,000

20,000

30,000

40,000

50,000



��$��One of the key challenges for the sector in the backdrop of market turmoil, fears of a �� the execution of existing large order books. Today, most EPC companies are leveraged �� !�� $�� <�� "��of these companies. In addition, delays, cost overruns, slow payment mechanisms and litigations add to the increased requirement for working capital. Working capital requirements of EPC companies range from 30% –70% of their annual revenues. $�� >�� short-term hurdles.

It has been observed that fund-raising challenges vary depending on the size and scale of the companies. Most large- sized companies are listed entities that currently trade ��$�� dilution. Furthermore, most of them have resorted to equity dilution in public markets in the recent past in order to raise the required funds to funnel the high growth witnessed by the sector in the last few years. Promoters of large construction companies do not own stakes of more than 50%-60% in their companies, thereby restricting their ability to raise further funds through equity dilution, without loss of control.

Most mid- sized unlisted companies have private equity investors who had invested capital in these companies. Companies are keen to provide an exit option to such investors, but existing capital markets are not conducive for an Initial Public Offering (IPO). On the other hand, some such companies are crunched for funds due to their investments in the asset development business. Their requirement of funds needs to be met through private equity capital infusion, promoter infusion or alternative sources of ��>>��

Lastly, small- sized companies have been observed to be under the highest pressure for ��*�� >��the scale and size to bid, win and execute large- sized projects. Private equity players, while interested in such companies, are very selective about the ones in which they invest. Only strong promoter-backed companies with healthy order books have been successful in raising funds and entering the high growth trajectory.

Therefore, how do companies meet their immediate requirements? It is well known that interest rate scenarios are only short-lived, and in the medium term will correct to levels that will help companies squeeze in additional margins. In the interim period, �� willing to help companies tide over the current tight situation. The only consideration for � ��>�� !�� retain control.

Any project is therefore subject to several events — some known and some not — that may cause delays in completion and overruns in costs. While all the risks cannot be mitigated, it is best to be informed and provide for such unforeseen events to ensure �� '��<�� !��

4



As is evident from the previous sections of this report, the EPC sector has evolved over �� $�� economic growth. However, as is customary in any business, with changing times, the �� H��>�� 5�� a varied approach to overcome business challenges – some have been discussed in this report.

;��0��Players traditionally developed skill-sets in their chosen infrastructure sub-sectors. While building a niche is important, it is equally necessary to have competence in other sub-sectors. It is a known fact that concentration in a particular sub-sector could lead to impediments to the future growth of organizations.

None of the sectors are insulated from the vagaries of time. These include the highways where there is stiff competition, irrigation where the project pipeline has been �� and obtaining environmental clearance prevent project take-off, railways which are yet to freely explore privatization or airports which have yet to develop a critical mass for �� <�� environment with evolving viewpoints and policies.

$�� <��¡�� adversities.” Companies are spreading their services to several sub-sectors to reduce �� and above, diversify.

Recent trendsJ Slow movement of irrigation projects causing irrigation- focused companies to

diversify

J Stiff competition and pricing in the highway space resulting in some players being reluctant to participate

J Exploration of new sectors including the defense, nuclear, aerospace, contract mining, power transmission and urban infrastructure segments

Overcoming challenges: Key trends and recommendations

Sector reference: size, complexity and competition


0

1

2

3

4

5

0 0.5

Storage

Railways Water

Railways Oil and gas

Power

Roads

Irrigation

Ports

1 1.5 2 2.5 3 3.5 4 4.5 5

Com

plex

ity

Competetion


��@��1��J Explore sectors with future potential

J Explore wider geographies and expand client base

J Carefully select projects

J Avoid the rat race

D��7*��0��The value chain generally encompasses multiple-functions and roles comprising developers, contractors and suppliers, along with other participants such as design �� '�� "� �� have demonstrated an increasing trend and willingness to gain a presence across the value chain. Contractors are forming alliances with project management companies to handle complex projects and enter the arena of engineering, procurement, construction and management (EPCM). Contractors and developers interchangeably perform dual roles. Developers have been adopting strategies ranging from inorganic growth to in-house startups to play a greater role within the construction space. Suppliers and ��

The primary reasons leading to the emergence of new roles across the value chain in the engineering and construction industry are rising competition, the increasing complexity of projects, requirement of technical expertise and knowhow, and the selection criterion for bidding, including tender offer eligibility norms, and cost and time constraints.

EPC contrator's

inter-changing roles

Developer

Contractor

SupplierProjectmanager

Financer

Design consultant

Inter-changing roles


Recent trendsJ 5�� <

based revenue base.

J Most civil EPC contractors are foraying into PPP opportunities, especially into the highway sector.

J Large construction companies and developers are moving higher along the value chain and creating in-house PMC and high value engineering divisions.

J Financial institutions are venturing into the development space, based on their infrastructure skills.

J Most private power producers such as Lanco Infratech, GMR Energy and GVK Energy have opted to chose suppliers through joint ventures with international suppliers such as Mitsubishi, GE, Hitachi andAlstom.

J =��"�¦�=��"3�5��chain. For example, IL&FS has ventured into project development through ITNL and subsequently entered contracting through IL&FS Engineering 32.

��@��1��J ��!��

J Have a presence across the value chain to enhance overall margins

J Control various functions to complete projects within timelines and budgets

32 “Projects,” IL&FS company website, http://www.ilfsindia.com/projects.asp accessed on 3 October 2011

��


Doosan, Hyundai, Mitsui, Mitsubishi have now turned into equipment suppliers

L&T, HCC, NCC, Gammon, Sadbhav, IVRCL, Navayuga, etc. turned developers to capture captive EPC

–

–

�� Developer Supplier

Contractor

Developer JSW Energy venture into equipment manufacturing

GMR, GVK developing in-house construction business

SupplierBGR energy foray into EPC; Tecpro, TRF, McNally’s venture into power EPC

��

Lanco’s foray into power development –


L��.��=��)��geographiesThe Government’s approval for 100% FDI investment in infrastructure projects through the automatic route has encouraged various international players to establish their presence in India. These global giants provide the latest technology and quality to domestic contractors through strategic alliances, joint ventures and partnerships.

Global economies have seen extreme contraction in recent years. While some are �� "�� 3;� �� opportunities in the infrastructure andconstruction space.

Due to the shrinking global economy and increasing opportunities in India, several European players are exploring the possibility of an entry into the Indian markets. Four �§��?5=��: �� 33 are evaluating the prospect of entering India and are seeking joint ventures on Indian turf. Several other international players such as Toyo of Japan, Samsung of Korea, Leighton of Australia, Bechtel of USA and IJM of Malaysia have already established their presence in India and undertaken some landmark projects in the country.

The presence of global players in the Indian industry provides the following value additions:

J Access to latest technology and equipment: For instance, a strategic partnership between Reliance Industries Ltd. (RIL) and British Petroleum (BP) would help RIL to gain access to deep water exploration technology for its KG basin and augment its production levels.

J Access to global project management and risk management capabilities

J Elimination of out-dated practices and improved quality and work-practices due to increased competition

J Indian players planning to diversify to new sectors without any prior experience in them — opportunity to move up the value chain by partnering with foreign players with sector expertise

33 http://enr.construction.com/toplists/GlobalContractors/001-100.asp

GDP growth of India and the world

Source: World Bank website, DataMonitor Country Report

-10

-5

0

5

10

15

20

2007 2008 2009 2010

World India Europe USA China

GDP

grow

th (%

)


Similarly, leading Indian construction houses have ventured into global waters seeking strategic tie-ups and superior technologies. While most purchases have been distress acquisitions, the strategic intent has been to bring home the technology.

Lastly, many contractors have expanded their horizons to bid and execute projects in global markets, primarily in the Middle East and Africa. Punj Lloyd and KEC International have already enhanced their international presence in regions where rapid infrastructure development and industrial growth offer ample opportunities. Others such as Gammon (through its Italian acquisition), L&T, Patel (through its US acquisition), HCC (through its Swiss acquisition) are making selective entries on a case-to-case basis.

Recent trendsJ Active interest of international players in Indian PPP projects, especially in the

highways sector, e.g., the recent award of the Kishangarh-Udaipur-Ahmedabad mega highway project that had 11 shortlisted bidding consortiums, 8 of which had foreign partners

J Indian companies evaluating distress purchase options in international markets, especially in Europe, the Middle East and Africa

��@��1��J Enter new geographies after assessing political situation, regulatory environment

and resource availability

J Identify clear strategic intent to enable value maximization

J Enter JVs with international majors to gain access to technology and new regions

L��O��7or mergers and acquisitions and joint ventures$�� investments, driven by government support and attrctive opportunities available in India. Between FY07 and FY11 (up to August 2011), 208 private equity deals worth INR697.6 billion took place across the infrastructure sectors.34

Maximum investment has been made in the power sector (close to 45% of the total private equity infrastructure investment between 2008 and 2010).35 Private equity in the construction sector has been to the tune of 8% of the total private equity infrastructure investment over this period. Companies necessarily resort to raising �� are over-leveraged and it may not be healthy for them to raise more debt. Private equity is also raised under circumstances wherein companies want to establish their benchmark valuations. Primarily, the funds are utilized to meet working capital requirements, asset funding or debt retirements.

34 ¡=�� /"�� ¢"��"�� ?��__35 “India private equity report 2011,” BAIN & Company


Mergers and acquisitions are also popular. Several pure-play developers who did �� the construction business in addition to their own segment and have been exploring possibilities to develop the required expertise either organically or inorganically. Moreover, corporate organizations wanting to establish their presence in the infrastructure sector are also actively pursuing opportunities to acquire construction companies, which would grant them immediate access to resource pools and opportunities. Moreover, global players are treading a similar path to establish their footprints in the country. They are also forming joint ventures with construction houses, wherein the former contributes the technology and knowhow and the latter local expertise and coordination. 3637

Selected private equity transactions

Date Investor Target Deal size (INR billion) Stake

May-11 IDFC GVR Engineers 1.5 20%

Mar-11 3i Group KMC Infratech Ltd 5.0 NA

Mar-11 Motilal Oswal/ IDFC GR Infraprojects 0.8 NA

Jan-11 Jacob Ballas PNC Infratech 1.5 NA

Nov-10 Chrys Capital Pratibha Industries 1.0 12%

Dec-09 Aquarius India Vijay Nirman Company 0.3 NA

Dec-09 Barings, Sequoia Coastal Projects 2.5 16%

Dec-09 Franklin Templeton GKC Projects 0.6 12%

Aug-09 Standard Chartered PE Man Infraconstruction 0.7 16%

Aug-09 Standard Chartered PE Ramky Infra 2.0 10%

Source: Press clippings

Selected merger and acquisition transactions

Date Buyer Target Deal size (INR billion) Stake

Apr-11 Welspun Infra Projects Leighton Contractors 4.7 35%

Dec-10 Sintex Infra Projects Durha Constructions 0.4 30%

Mar-10 HCC Karl Steiner (Switzerland) 1.5 66%

Mar-10 Welspun Infratech MSK Projects 4.0 61%

Sept-08 Gammon India =�� "�� 4.6 50%

Jun-08 Gammon India Franco Tosi Meccanica Spa (Italy) 5.7 75%

Apr-07 Larsen & Toubro Mitsubishi Heavy Industries 3.0 51% 36

Sept-06 Kirloskar Brothers Ltd Aban Constructions 0.6 100%

Jun-06 Larsen& Toubro SapuraCrest Petroleum 0.1 60% 37

Oct-04 Italian-Thai Development Plc Skanska Cementation 0.8 80%

Source: Press clippings

36 “Larsen & Toubro enters JV with Mitsubishi Heavy Industries to make super-critical boilers,” The Economic Times, 18 April 2007, via merger market.

37 “L&T, SapuraCrest Petroleum form JV,” mergermarket, 08 june 2006, ©2006 mergermarkets limited

Competition is ushering an urge for consolidation by major companies. Large foreign corporates increasingly view M&A as an entry strategy and domestic players are buying stake in foreign companies �� *�� interest in infrastructure, they have been observed to be selective about their investments.

Kuljit Singh, Partner and Leader, Transaction Advisory Services-Infrastructure Practice, Ernst & Young India


Recent trendsJ The nature of private equity transactions have changed from plain vanilla equity

investments to structured deals (be it convertibles or preferential instrument).

J Private equity investors are keen on investment due to their long-term infrastructure potential.

J Companies that are unwilling to divest at an early stage have also shown a keen interest in raising their mezzanine capital,

J Investors have shown an interest in investing growth capital in companies with ��

J With over 150 participants in the sector and multitude investment opportunities, investors have chosen to make selective investments in the sector.

J Most merger and acquisition transactions have been undertaken as an entry strategy — be it a new geography or sector, or to gain access to technology and participate in complex projects.

J Mergers and acquisitions may evolve into an optimal strategy for the creation of size and scale; small and mid-sized players may use consider mergers with similar-sized companies as means of inorganic growth.

��@��1��J ;:��

management participation.

J A valuation and pricing mismatch may be bridged through innovative structured instruments.

J 5�� !�� company to complement one’s existing skill-sets.

Q��2�� 9��<��$��9��2��Today, EPC projects are large in size and require huge resources. They entail complex interlinked activities, multi- party involvement and a substantial risk for the contractor to complete a project within time and budget. To manage and coordinate multiple and �� project management.

Most global players give project management utmost importance and demonstrate their capabilities through superior project designing and effective project management. The resources deployed on a project can be outsourced, but having an overall control through an experience project management team is considered the key to mitigating time and cost overrun risks. Ineffective project management not only cause delays, but �� <�� to a project and the company. While Indian companies have been traditionally outsourcing such services, many are now moving toward owning such capabilities in-house.


��@��1��J Create an in-house team of experienced project management personnel

J Adopt and rely on sophisticated project management tools and techniques

J Develop a tracking system for all critical activities to avoid slippages on a daily basis

;��.��Increasing project opportunities bring with them the added onus of appropriate project selection. Owners are increasingly focusing on the technical capabilities and establishments of the bidder. It has been witnessed that Indian companies are placing more and more importance on pre-bid project evaluation. Several measures are �� >�� project.

Category Risk Diligence measure

Political Political stability of the country

J Adequate studies to understand economic and political cycles in the country

J Appropriate remedies in contracts to factor in any force majeure events

Political/ Regulatory Delays in approvals and land acquisition

J Ensuring substantial approvals and land are in place prior to work commencement

J Onus of procurements to lie with the owner

Environment Unfavorable climatic condition and topography

J Environment Impact Assessment clearance

J Adequate geo-technical surveys and climate surveys prior to construction phase planning

Technical Design changes/inadequacies

J 5��

J Appropriate remedies in contracts to factor in any change in design

Technical Availability of resources J Adequate studies to source procurement of materials and build appropriate transport costs

Technical Resettlement and rehabilitation; utility shifting

J :�� >� �� ^¦^��

J Appropriate contractual obligations on owner for unforeseen delays due to utility shifting

Financial/ Operational Cost estimates J Detailed understanding of scope of work

J Detailed BOQ estimation at time of bid

J Provision for unforeseen costs escalation

J Clear contractual obligations on both parties for cost escalations to avoid ambiguities

J Clear payment mechanisms for change in scope provisions

Financial Liquidity and credit shortage

J Adequate mobilization advance

J Milestone payments to be recovered within time

Financial Foreign exchange and �� !��

J Appropriate hedging mechanisms for foreign exchange

J Appropriate interest rate budgeting during bid —may also resort to hedging

Market Delay in payment from owner

J :��

J Appropriate remedies in contracts to penalize client for delay in payments

Contractual and legal Unfamiliarity with the local laws and regulations

J Consult appropriate legal experts

J Clearly understand variations from home country laws

Force majeure events Risks associated with external hazards

J Appropriate remedies in contracts to factor in force majeure events


��After a contract is awarded, various general and special conditions are captured through a contractual arrangement. Most Indian public sector clients have standard contracts, which the contractors are unable to negotiate. However, private sector clients have negotiated contracts, and astuteness at the early stages can minimize arbitration risks. Many contractors chose to follow the FIDIC38 silver book for EPC contracts, to maintain standardization. FIDIC membership today numbers 86 national member associations, representing about one million professionals39.

��@��1��The critical parameters to be observed in the contract are highlighted below:

J 5��

J ;��

J Price escalation clause with a standard formula

J Early completion incentive framework/delay penalties

J Clear process framework in the event of change in scope and design

J ��

J Interest penalty in the event of delay in payments

J Clear distinction between defect liability and maintenance periods

J Dispute resolution framework

L��1��$��In India, the Government’s role in infrastructure creation is inevitable. Over the years, liberalization of regulations and the planned strategy of the Indian Government to promote infrastructure development has spelt opportunities for EPC companies. Realizing that planned infrastructure creation cannot succeed without the participation of the private sector and foreign players, the Indian Government has created a policy framework that is conducive to private and foreign investments and offers attractive opportunities for PPPs. As part of its policy reforms, the Indian Government has been continuously attempting to simplify the approval process, easing out credit generation for the infrastructure sector and setting up agencies to expedite growth through a planned release of projects.

Furthermore, several awarding authorities have also initiated regulatory changes to � �� The power and highway segments have seen constant improvements during the past decade due to regulatory transformations. The implementation of BK Chaturvedi’s recommendation in the highway segment has resulted in increased activity, with more players bidding for projects. Other segments such as the ports and railways are also attempting investment-conducive regulations.40

38 �"3"5�� of contract for the construction Industry worldwide. It is best known for its range of Standard Conditions of Contract for Construction, Plant and Design-build, EPC/Turnkey projects, and design, build and operate projects.

39 FIDIC website��/HH��_�� H�� H40 “Construction sector,” Centrum Research, 30 August 2011, via Thomson Research


Recent trendsJ New EPC models in the process of development by NHAI ,wherein the contractor will

accept the risk and responsibility for design as well as construction

J Infrastructure companies permitted to raise funds from overseas markets: In the infrastructure sector, borrowings through external commercial borrowings (ECBs) have increased by over 65% to US$17.4 billion between September 2010 and August 2011. (Source: SEBI)

J The Government has initiated a proposal for the creation of Infrastructure Debt ��"3�� !��<�� projects — the proposal is still at the policy stage.

J Announcement of the Takeout Financing scheme under the Union Budget 2009-10 and setting up of the India Infrastructure Finance Company Limited (IIFCL) as a �� <�� projects: Recently, IIFCL, LIC and IDFC entered an MoU to avail of takeout of debt of up to 50% of the total project cost in the ratio of 20:20:10 by the three institutions, ��$��INR300 billion.

��@��1��J �� :;5��

their participation in infrastructure building.

J ��<�� :;5players.

J ��

J Grievance redressed mechanism should be more active.

51Engineering, Procurement and Construction (EPC)/3 ��

5



Driven by and dependent on the infrastructure growth story, the Indian EPC market has a plethora of opportunities to offer - an estimated spend of INR17.1 billion. over the Twelfth Five Year Plan — 50% of such opportunities are expected to be funded by the private sector. What will differentiate one player from the other is the soundness with which such opportunities are secured and managed. Challenges are inevitable in the current EPC market scenario, but the approach to management of such challenges will be the key to continued success. With global giants entering Indian markets, EPC contractors wanting to ride the wave of double-digit growth will have to constantly improvise and improve their modus operandi to maximize value for their shareholders.

*�� >�� '�� viewed with long- term commitments, giving due consideration to risks that can span the life cycle of a project. Resource constraints in manpower, material, machinery and funds are a distasteful reality in the sector. Competition has to be defeated, not through reduction in pricing or margins, but by constant technical innovation and strategic tie-ups to gain an edge over one’s peers. In certain highly competitive sectors, consolidation is inevitable. It is also a good idea to absorb multiple roles in the value chain to control the overall process – along with related revenues and margins, of course!

Effective project management is increasingly being recognized as a large contributor �� While Indian contractors have mastered the art of planning, the need for regular supervision and monitoring is gaining prominence among them, to ensure that on- paper sketches reach their logical conclusion with the desired results – if not better ones. Global players have adopted this approach; domestic players are in the process of doing so.

3�� '��prudent to diversify into other sub-sectors and regions. The EPC market is promising, but with the buoyancy in political policies, the areas of infrastructure development could shift focus over the years within infrastructure sub-sectors. Diversity in skill-sets, being able to adapt and secure contracts based on the requirements of infrastructure development may be a long-term mitigant of the vagaries of time. Indian players are foraying into the international arena on an opportunistic basis. Moreover, regional players are also realizing the importance of having a pan-India presence in this competitive environment.

With the gargantuan size of projects on offer, the passion of domestic players �� 5��this requirement is the deteriorating working capital requirements of companies. However, with rising interest costs and over- leveraged balance sheets, there is little scope for raising funds through this route. With FDI in infrastructure opening up, global funds have demonstrated their keenness to invest in the sector through �� =�� companies in the last few years. Some are also exploring the possibility of inorganic growth through the merger and acquisition route, in which complementing skill-sets are acquired to achieve quick growth.

�� !��"��#� �� $&�� key to success.

Conclusion

6



Taxability, under the Indian direct tax laws, of foreign EPC companies undertaking projects in India has always been on the top of the mind; there are controversies on taxability of consortium, offshore supply etc. On indirect tax front, GST is likely to be introduced in near future to overcome the current myriad of multiple indirect taxes being levied at different stages.

Q��Given the different ways (mentioned above) adopted by the players to execute EPC contracts in India, the taxability of the income steam is a relatively complex and fact-driven exercise. Some relevant direct tax implications for EPC contracts are elucidated below.

��One of the integral and most crucial elements of an EPC contract is the supply of equipment, which often has been the domain of foreign companies (barring a few Indian ��:��¦$��?��as the supply of equipment is to an EPC contract, so has been its taxation, and this has drawn existing and active foreign companies into prolonged tax litigation in Indian courts and with the tax authorities. Generally, offshore supply should not be taxable in the following cases:

J All the elements of the supply of equipment is concluded or undertaken outside India (title of goods, delivery, risk, etc.)

J The contract is on principal-to-principal basis.

While law and jurisprudence seem to be in favor of non-taxability of offshore supplies, the issue is far from settled, as is evident from the fact that several companies are still engaged in litigation with tax authorities. In view of the uncertainty of tax costs, more and more foreign companies are now approaching the Authority for Advance Ruling to seek certainty on tax costs on offshore supplies and avoid prolonged tax battles.

��Historically, services rendered outside India in connection with Indian projects were taxed in India. However, the Supreme Court, in one of its rulings, interpreted the tax laws to mean that for taxes to be levied by the country, the offshore services should be rendered in India. This was followed by a series of judgments, and some of them disagreed with the Supreme Court’s ruling.

The Government sought to clarify its position on taxability of offshore services by bringing about amendments in its tax laws. Pursuant to amendments in domestic tax law, offshore services have been brought within the tax net.

��More often than not, large infrastructure projects witness the joint venture or partnership of two or more companies that form a consortium to bid for a project. The bid, if found technically and commercially competitive, is selected and the project owner awards the contract to the consortium. The consortium members, either under the contract with the project owner or through an inter-se agreement between the consortium members, agree on the respective scope of work and fees. The project owner generally insists on a single contract being signed, and at times, make payments in favor of a lead consortium member in India. Furthermore, the project owner insists on having joint and several liabilities on the consortium members.

Supplemental: Know your tax


The taxation of consortiums has in the recent past attracted the attention of the Indian Revenue Authorities (IRA). The IRA takes a cue from such acts of project owners, and more often than not seeks to tax a consortium as an Association of Persons (AOP) and disregards the independent tax status of the members of the consortium as taxable ��$�� ?�;�� of India, unless its control and management is situated wholly outside India. If the consortium is taxed as an AOP in India, its worldwide income may become taxable in the country. As a result, the income of a member of the consortium, which might otherwise have not been subjected to tax in India (in the hands of the members as independent taxable entities), it is likely to be taxed in the country if the consortium is treated as an AOP, e.g., income arising from offshore supply of goods by a foreign contractor.

Stability and consistency in the tax policies of the Government are much needed at this stage to sustain the growth of the infrastructure sector in India.

��.��'Foreign companies are often required to maintain an onshore presence (in India) to undertake or monitor the onshore scope of work. This often results in a continuation of their taxable presence in India — popularly known as PE. The IRA has in the recent past aggressively sought to evaluate the role played by the PE of a foreign company constituted in India in the execution of the project, and attribute a large portion of the � �� "��$�� need for their presence in India as well as the role played by their PEs.

V��Under Indian direct tax laws, a project owner is required to withhold taxes on payments made to EPC contractors. This includes those made for offshore as well as onshore work. However, the rate at which the taxes require to be withheld depends on the fact pattern of each case.

Q�.�� >��>��Q >>'India has entered the DTAA with various countries. This provides a mechanism for avoiding being levied taxes on income in the home country as well as in the source �� $�� 3$??� ��?�� applicable for a tax resident of a country having a DTAA with India.

��Q�� Q �'With current direct tax laws proposed to be replaced by the DTC, it is imperative to analyze its impact. While tax provisions under the DTC are broadly similar to current tax laws vis-à-vis the EPC sector, the following key changes proposed by DTC merit some discussion:

Offshore servicesThe DTC enumerates unambiguously that offshore services will be taxed in India, irrespective of where the services are rendered. Therefore, the controversy surrounding the taxability of offshore services seems to be put to rest. While this may add to the tax cost of foreign companies, and ultimately to that of projects, the certainty of tax costs will make it easier for foreign companies to take a decision on pursuing Indian contracts.


D��0�� D� 'As discussed earlier, foreign companies may constitute a PE in India (for EPC contracts in the country) by virtue of the presence of its employees in the country or by setting up �� '�� "��the DTC proposes to levy BPT at 15% on the income attributable (directly or indirectly) to the PE. The BPT will be in addition to the normal corporate tax rate of 30% (reduced from 42.024% under the Act). While the tax rate applicable to foreign companies has �� ;$�

V��Under the Act, the taxes from such payments (for provision of drawings, designs rendering of technical services, etc.) to foreign companies are to be withheld as per the rates prescribed under the Act or the relevant tax treaty, whichever was more �� $�� 10%-15% for royalty or fees for technical services, while the Act prescribed a rate of 10% (plus surcharge and cess) in the absence of a PE. However, under the proposed DTC, withholding tax rates on aforesaid payments have increased to 20%. While the �� ?��<¬<�� rate increase in the DTC could adversely affect the overall tax liability for the offshore services.

��The EPC Industry is at present subjected to multiple indirect taxes, both at the Central and state levels. The overall impact of such levies is substantial, and therefore, it is crucial for companies executing EPC contracts to structure their contracts, while considering various tax implications arising under Indian domestic tax laws. A gist of the relevant indirect tax levies applicable to the EPC industry are tabulated below.

Key indirect taxes applicable to the EPC Industry in India

Tax/Duty Governing authority Nature of levy

Customs duty Central Government Duty on import of goods into India (general effective rate 26.85%)

Excise duty Central Government Duty on manufacture of goods in India (general effective rate 10.30%)

Service tax Central Government $�� effective rate 10.30%)

Central Sales Tax (‘CST’)

Central Government Tax on sale of goods between two states at �� '��conditions)

Value Added Tax (‘VAT’)

State government $��"�� #�state and commodity) – typically the VAT rate varies from 5% to 15%.

Entry tax/ Octroi

State governments/Local authorities

Levy on entry of goods into a particular state or local area (Entry tax rate varies from State to State.)


Typical indirect tax implications in respect of the various components of the EPC contract are outlined below:

+��O��Import or procurement of equipment from outside India attracts levy of custom duty, the �� for customers may attract VAT or CST implications if the title to goods is passed in India. Importers may explore the possibility of effecting high sea sales or sales in the course of import to mitigate the VAT or CST exposure.

Offshore serviceProvision of offshore services may attract levy of Service tax in India under a reverse charge mechanism as import of services. In the case of import of services, the liability to pay service tax is of the recipient of the service. Availability of credit for erection, commissioning or construction services needs to be evaluated in detail since this may be restricted, depending on the nature of the output activity orservices undertaken by a EPC contractor.

+��O��Procurement of equipment within India may attract levy of Excise duty. The possibility of claiming input credit of excise duty paid to equipment vendors may be explored. Furthermore, supply of locally procured equipment to a customer will attract VAT/CST duty. EPC contractors may explore the possibility of effecting a sale- in- transit to mitigate their VAT/CST exposure. CST paid on purchases will not be available as input credit, and accordingly, this is a cost to the project owners.

Onshore services; �� "��=� ��$��possibility of claiming Cenvat credit for Service tax paid may be explored to mitigate the overall reduction in the Indirect tax cost of a project.

+��9�EPC contractors may cover the entire scope of their work (supply of goods and services) under a single consolidated contract for a lumpsum price or may split this between civil works, supply and services components. Usually, the rationale for splitting an EPC contract is to limit the tax exposure and liabilities. A single consolidated contract for �� concerns, as listed below:

J 3�� goods and services, which may result in a dispute with respect to the value on which Service tax or Sales tax is paid by an EPC contractor.

J Furthermore, authorities can levy tax on the value of goods being provided by the project owner to an EPC contractor for use in the execution of the contract.

J Service tax or Sales tax may also be levied on the value of services or goods provided free of cost.


Accordingly, while evaluating indirect tax implications on onshore civil works contract, it is imperative to identify the appropriate nature of a contract, i.e., whether it is a spilt or consolidated contract. Assuming that a onshore civil works contract is a spilt contract, the following typical indirect tax implications are highlighted:

Service tax is levied on consideration received for pure service portion of a contract. An EPC contractor may explore the option of paying Service tax at the rate of 4.12% under the composition scheme prescribed under India’s Service tax legislation. VAT/CST will be levied on consideration received for supply of goods. An EPC contractor may explore the ��§?$�� <��§?$legislations.

Therefore, it appears that while making decisions on structuring of an EPC project or contract, companies need to take into account Indirect tax implications and address appropriately Indirect tax issues that may arise in the future.

��The moot point for the Government to consider as regards EPC contracts is that uncertainty of taxation and prolonged litigation is likely to increase the implementation cost of infrastructure projects. This could work as a deterrent for foreign EPC contractors wanting to enter India’s infrastructure space. This may deprive the �� infrastructure at an accelerated pace. The Indian Government is therefore encouraged to maintain consistency in its tax policies for taxation for EPC contracts.

“Given the current regime of complex tax structure and involved litigation due to ambiguities, sooner ��=$��<��¢

“Establishment of fast track dispute resolution or advance rulings for all players would enhance �� ¢

Samir Kanabar, Tax Director and Sub-sector Leader - Ports & Shipping, Ernst & Young India

7



Annexure: Indian EPC participants (listed players)

Large-sized Mid-sized Small-sized

ABB India Ahluwalia Contracts (India) Ltd. Atlanta Ltd.

Alstom Projects ARSS Infrastructure Projects Ltd. J Kumar Infraprojects Ltd.

Ashoka Buildcon Ltd. B.L. Kashyap Jaihind Projects

BGR Energy B.L. Kashyap KNR Constructions

BHEL BSEL Realty Marg Limited

Eicher India C & C Constructions Ltd. P B A Infrastructure Ltd.

Era Infra Engg. Ltd. CCCL Petron Engineering Construction Ltd.

Gammon India Ltd. Continental Construction Ltd. Roman Tarmat Ltd.

Genus Power Infrastructure Diamond Power Infrastrcutures Sujana Towers

HCC Engineering Projects Ltd Supreme Infrastructure Limited

I V R C L Infrastructures & Projects Ltd. Gayatri Projects Ltd. Tantia Constructions Ltd.

IL&FS Engineering I T D Cementation India Ltd. Transstroy (India) Ltd

IRB Infrastructure Ircon International Unity Infraprojects Ltd.

KEC International J M C Projects (India) Ltd. Valecha Engineering Ltd.

Lanco Infratech Jyoti Structures Ltd. Welspun Projects

Larsen & Toubro Ltd. Kalindee Rail Nirman (Engineers) Ltd.

Nagarjuna Construction Co. Ltd. Madhucon Projects Ltd.

Patel Engineering Ltd. Man Infraconstruction Ltd.

Punj Lloyd Ltd. MBL Infrastructure Ltd.

Simplex Infrastructure McNally Bharat Engineering Co.

Thermax Pratibha Industries Ltd.

Toyo Engineering Ramky Infrastructure Ltd.

Uhde India Sadbhav Engineering Ltd.

Shriram EPC

SPML

Unitech Power Transmission

Additionally, the market has over 100 unlisted promoter-driven companies that are active participants in the EPC space.


Notes


Notes

Ajit Krishnan

Tax Partner and Leader-Infrastructure and Real Estate

Kuljit Singh

Partner and Leader, Transaction Advisory Services-Infrastructure Practice

Sushi V Shyamal

Partner, Transaction Advisory Services

Transportation Infrastructure and Construction Sector Leader

Samir Kanabar

Tax Director

Sub- Sector Leader – Ports and Shipping

Sushi V Shyamal

Partner, Transaction Advisory Services

Transportation Infrastructure and Construction Sector Leader

Saket Jalan

Associate Director, Transaction Advisory Services

Helly Ajmera

Associate Vice President, Transaction Advisory Services

Ernst & Young leadership team

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