Graduate School of Business (HEC, Ecole des Hautes Etudes Commerciales) University of Lausanne (Switzerland)

NE-01-004

Negotiation game: Paranha Power Plant

Jean-Claude Usunier prepared this case solely to provide material for class discussion. The author does not intend to illustrate either effective or ineffective handling of a business situation. The authors may have disguised certain names and other identifying information to protect confidentiality. The Institute of International Management of the University of Lausanne (IUMI) prohibits any form of reproduction, storage or transmittal without its written permission. To request permission to reproduce materials, contact IUMI, HEC, BFSH1, CH-1015 Lausanne-Dorigny, Switzerland; phone 00 41 21 692 3310 ; fax 00 41 21 692 3495; email adm.mim@hec.unil.ch. IUMI/HEC, 2004 06 Version: (A) 2004-10-

A consortium, BDH, has been established between a US-based engineering company, a Swiss company belonging to the same sector and a German firm producing heavy industrial equipment. This consortium is in the final phase of negotiations to win a contract for building a turnkey electric power plant. The owner is the National Electricity Authority (NEA), a stateowned corporation which holds a monopoly on the transport and distribution of electricity in a Latin America. National Electricity Authority has issued the tender. The tender procedure was initiated eighteen months ago. At first there were about twenty potentially qualified contractors which submitted bids. Most of them were engineering companies originating from the main industrial countries, and some came from newly industrialized countries such as South Korea and Turkey. After a preselection phase, the number of potential contractors was reduced to a short list of five companies or consortia. The final selection process lasted for several months, as bids that were technologically incomparable had to be taken into account.

The consortium created by Brown Engineering Corp. (US), Duponval SA (Swiss) and Horst BauTechnik AG (German) was chosen as the organization with which the final negotiations would take place. But a Japanese competitor, Chikoda, has also made a very attractive offer and is equally in a position to supplant BDH, if BDH proves to be too demanding for National Electricity Authority. In fact BDH has a strong reference list, supported by similar plants it has built which are working effectively. Moreover, in addition to its offer, BDH provides a low-rate, long-term financing scheme for the buyer, which has been created by putting together export credits issued by banking organizations from the countries of the three members of BDH : US Eximbank for Brown, Swiss Banking Corporation for Duponval and KfW (Kreditanstalt fr Wiederaufbau) for Horst BauTechnik. The final price has not yet been settled, as there are still some important clauses to be discussed: 1. The supply of basic materials by the consortium, during the start-up of the power plant. 2. The possibility of signing a 'products in hand' contract. A 'products in hand' contract is a particular kind of turnkey operation, where part of the payment by the owner to the contractor is subject to the level of performance reached by the plant. After the start-up phase has been finished and individual pieces of equipment have been shown to work effectively, a phase begins where the contractor is assigned to operations. This means that a management contract has been signed. The variable fee may cover part or all of the turnkey operations as such and/or the management contract. In this case the consortium would agree to sign a management contract to run the operation until it reaches 100 per cent of its target capacity (400 megawatts). The proposal which served as a starting base for the final bargaining process was priced at US$105 million. Each one of the partners-to-be has naturally retained its right to improve its position, either by obtaining a rebate (the buyer) or by increasing this base price level by astutely negotiating supplementary services (the consortium). Since the inception of this tender, National Electricity Authority has made it known that the first power plant will be followed by the construction of two similar plants, all this being stated in the ten-year plan for the electrification of the country. It seems very likely that the contractor selected to build the first unit, if effective, will be well positioned for the next two orders which may possibly be placed by direct agreement between contractor and owner, that is, without a competitive bidding procedure. At the negotiating table are three representatives of the buying organization and three representatives of the BDH consortium, each one an employee of one of the companies: 1. For the buyer: (a) Mr Melo, who is in charge of project financing for industrial development at the Ministry of Finance. He might be a useful and even necessary go-between for many red-tape problems

related to administrative and financial issues which could arise when completing the project: payments, clearing customs for imported equipment, fiscal and social problems of expatriates, etc. (b) Mr Alves, who is the director in charge of energy at the Ministry of Industry. He is concerned with the coordination of this project with the other industrialization projects being undertaken in the country. There have been many negative experiences of this in recent years: two years ago, some ships with a full load of cement were stranded in the main sea port of the country because there was not enough unloading equipment such as docks and cranes. This caused severe delay on several projects. (c) Mr Duran, the third representative, is 38, much younger than both Melo who is about 50 and Alves who is 60. He has been trained in the United States and holds a Master of Science degree in Electrical Engineering. At National Electricity Authority he is in charge of new plants and investment project. He is reputed to be ambitious but also capable and hardheaded. In the long run he is seen as a possible chief executive for National Electricity Authority. Duran has confidence in the country's development projects and in the capacities of local managers to run the new plants effectively. 2. For the consortium: (a) Mr Smith, a project manager aged 42, who has worked for many years at Brown, the US member of the consortium. Brown will take charge of the boiler part and the plant monitoring system. Brown is ranked among the leading US engineering companies. It has a high reputation for technical excellence as well as for cost control. Project managers at Brown are partly compensated with a bonus based on the profit generated by the project. A sophisticated cost accounting system monitors actual and forecast costs and margins regularly during the project. When projects are completed after two to three years or more, final costs are calculated, with a minimal deviation from target costs. (b) Mr Robin from Duponval SA, a Swiss engineer who has worked for this company for the last ten years. Duponval has already formed several joint ventures with Brown, and Robin knows Smith because they have already worked together. Duponval SA is in charge of civil engineering and the total coordination of the work. This firm has established a good reputation world-wide for meeting delivery times. (c) Mr Dietermeyer, a Doctor of Law, aged 55, has worked for the last twenty years for Horst BauTechnik. Although he has not been formally trained in engineering, he has built up a good knowledge of industrial engineering on the job. In addition to this he has attended many training sessions which have provided him with an in-depth knowledge of the technologies of a large variety of turnkey plants. He is considered in his company a skilful, experienced and effective business negotiator. His law background is very useful in discussing precise clauses, understanding what is at stake and the possible legal consequences of a specific clause. Horst

is in charge of supplying and installing turbo-alternators and all the electrical parts in the plant. BDH consortium has been chosen as the contractor with which National Electricity Authority is willing to negotiate the final agreement under the supervision of the Ministry of Finance and the Ministry of Industry. A sum of US$105 million is the starting point for the discussion; until now it has been considered a lump sum for a turnkey operation contract. But things have not yet been fully settled. The Latin American team wishes to negotiate either a rebate on this price level, arguing that there will be future projects which could be awarded to BDH, or complementary services or guarantees, which could be granted for free. These might possibly be the following: 1. The free supply of materials required for production during the start-up phase, which will last one month. 2. Free technical assistance for the industrial management of the power plant, in order to be able to serve consumers and to manage the electricity distribution network properly. 3. A commitment from BDH to subcontract part of the job locally, especially the less sophisticated part of the civil engineering work. BDH naturally prefers to maintain its price, for which it had been selected from harsh competition. In fact there were some cheaper competitors, sometimes $15 million less. But neither their reference lists nor their financing deals matched BDH's bid. To tell the truth, BDH is somewhat worried about the delay penalty clause which National Electricity Authority wants to include. The fine is supposed to be 1 per cent of the total price for each construction month beyond the standard completion time. The consortium foresees that there could be some delay. It fears that it might be difficult to assign clear responsibilities to either the contractor or the owner (or the state authorities of the country, or a large subcontractor, especially if it was a local business). Usually turnkey contracts include a customs franchise for all the equipment imported in order to build the plant. But it is not that rare for customs officers not to apply these rules immediately, and it may delay the customs clearance of these components and equipment, thereby delaying the completion of the plant. The parties have agreed to discuss the issue of transforming this pure turnkey operation, paid for by a lump sum, into a 'B.O.T.' contract ('Build-Operate-Transfer'). Under the B.O.T. scheme, part of the payment will be subject to a variable scale related to the level of capacity reached during the management contract period after the plant has been completed and started up. The possibility of a management contract has been discussed. It will probably be added to the turnkey contract (which includes the construction start-up phase, but no more). This management contract will encompass handling the industrial management procedures, the accounting system, setting salaries, customer service and providing training

programmes for local executives. Progressively, local management is supposed to take over the management of the project. The basis on which the variable payment would be calculated has not been clearly settled up to now. This basis could be: the whole amount of the management contract, part of it, or the whole amount of the management contract plus part of the $105 million turnkey project. The Latin American proposal for this final negotiation includes the following elements: 1. The price of the management contract plus US$10 million (on top of the turnkey price) to become a variable and conditional payment, subject to the capacity level reached within a certain time span. This scheme would extend throughout the total thirty-six months of the management contract period. 2. For this variable part the proposed payment scheme is as follows: (a) 15 per cent after six months if the output reaches at least 50 per cent of the target capacity; (b) 15 per cent after twelve months if the output reaches at least 60 per cent of the target capacity; (c) 15 per cent after eighteen months if the output reaches at least 70 per cent of the target capacity; (d) 15 per cent after twenty-four months if the output reaches at least 80 per cent of the target capacity; (e) 20 per cent after thirty months if the output reaches at least 90 per cent of the target capacity; (f) 20 per cent after thirty-six months if the output reaches 100 per cent of the target capacity. 3. The management contract may grant decision-making powers to the consortium in the following matters: recruiting personnel (workers, not the management), operating the plant and choosing supplies of appropriate quality and price. The selling price of the output as well as the operating costs are to remain the sole responsibility of National Electricity Authority. The negotiation takes place at the headquarters of National Electricity Authority in Port Paranha, where the power plant will be built. The talks simply aim at finalizing an agreement for beginning the construction as soon as possible. No detailed agenda has been prepared for the negotiations. Discussion begins....