Surety bonds are insurance products that secure the financial risk of one party against the default of another party to the same contract. Most commonly this is associated with contractor default.
What is a surety bond?
A bond or surety is a promise by guarantor (the surety company) to pay one party (the obligee) a certain amount if a second party (the principal) fails to meet some obligation, such as fulfilling the terms of a contract.
The surety bond protects the obligee against losses resulting from the principal’s failure to meet the obligation. With other words: the bond provides a guarantee that the bonded company or person will perform its obligations in good faith. Failure to do so may trigger a requirement that the surety company, who provided the bond, steps up in its place. In that case the surety company is obligated to find another contractor to complete the contract or compensate the obligee for the financial loss incurred.
Four types of surety bonds
- Bid bond
Ensures the bidder on a contract will enter into the contract and furnish the required payment and performance bonds if awarded the contract.
- Payment bond
Ensures suppliers and subcontractors are paid for work performed under the contract. Examples: advance payment bond and labor & material payment bond.
- Performance bond
Ensures the contract will be completed in accordance with the terms and conditions of the contract. Examples: performance bond and maintenance/warranty bond.
- Ancillary Bond
Ensures requirements integral to the contract, but not directly performance related, are performed. Examples: decommissioning bond and interconnection bond.
Information about the most common bonds
Advance payment bond
The ratio of project hard costs associated with the generating equipment is quite high and manufacturers often require substantial deposits for the manufacture and delivery. Or perhaps the project site is very difficult to access and requires significant infrastructure in place before any generating installations can begin.
In either case the EPC contractor may seek up front money to defray these costs, in advance of any work put in place. The lender/financing entity, in exchange, would require some sort of guarantee that they will be reimbursed if the contractor fails to achieve certain milestones. This guarantee may be in the form of a letter of credit, or a bond. A typical such bond would be for 10% of the contract value, but could be higher.
- Underwriting is almost exclusively based on the financial strength of the applicant.
A typical performance bond would ensure that the project was built to specification, within the contractual time allotted and for the agreed upon price. Often these bonds are required by contract. Depending on the jurisdiction, the bond amount would be anywhere from 10-100% of the contract value. In the U.S it is usually 100%, 50% in Canada & Mexico and 10-20% in South America, the EU and others.
The percentage guarantee would also likely dictate the language of the bond. Higher percentage bonds typically are “remedy” in nature. In the event of a default the obligation of the surety is to remedy the problem. Note there must be a legitimate default, declared by the beneficiary, and presumes the beneficiary is not in default of its obligations to the contractor. Resolution by the surety may include providing financing to the contractor, or replacing the contractor with a completing entity, or (extremely rarely) writing a check to the beneficiary and allowing them to complete.
Lower percentage bonds may have these same characteristics, but are more likely to be “demand” in nature and much more like letters of credit in wording. They do not require a formal default, nor is there much of a chance to refute the demand. It is typically “pay now, argue later”.
In cases of conflict between the language of the bond and the language of the underlying contract, the latter usually prevails. As such the terms of the contract weigh heavily in the underwriting. Questions that relate to output guarantees, defective workmanship warrantees, definitions of default and damages, etc. all factor into the equation.
Cost of the bonds differ markedly because of the risk differential.
- Underwriting is based on several factors:
- Language of the contract
- Financial status of the applicant
- Previous experience of the applicant on similar type/size projects
- Labor vs material risk. Subcontractor risk evaluation.
- Positive confirmation of project funding
- Legal/political jurisdiction of project site
Labor & material payment bond
These bonds guarantee that the EPC contractor/ principal named on the bond, will use the contract proceeds to pay material vendors, subcontractors, labor and all other costs directly incurred in the prosecution of the bonded contract.
Payment bonds typically go hand in hand with performance bonds. Since these are usually co-written with performance bonds, no additional underwriting is required.
Should a payment bond alone be required, underwriting would rely more heavily on adequacy and confirmation of project funding, and the financial capacity of the applicant.
A maintenance bond guarantees that the work will be free of defective material and/or defective installation work for a stated period. Maintenance bonds become effective after a project has reached substantial completion. The effective date of a maintenance bond also effectively serves as closeout of the performance bond. Maintenance bonds are often required by contract, along with requirements for performance bonds.
The underwriting of maintenance bonds revolves principally around two factors:
- Duration of the guarantee
- Exposure to process or output during the warranty period
Warranty period up to three years are common. 3-5 years maintenance bonds are difficult to obtain. Beyond 5 years is almost impossible.
The essence of decommissioning bonds is to guarantee that the installation will be dismantled and removed at the end if its useful life. As opposed to the advance payment bond, performance bond and labor & material payment bonds, which are required of the EPC contractor, decommissioning bonds are required of the project developer/owner. The demand usually comes from the property owner and/or local governmental authority.
These bonds can be very challenging to underwrite due to the length of the obligation. PV installations are designed for operation 25 years into the future. Writing a bond for that length of time is virtually impossible without significant collateral.
Bonds to address these requirements are either annually renewable, or run for an acceptable specified period of time (3 or 4 years) with renewal options. The only other choice for the developer is a letter of credit.
Decommissioning bonds are pure financial guarantees and underwritten solely on the strength of the applicants balance sheet.
Most of the PV installations are connected to the local power grid to distribute electricity. The utility company, private or state-owned, would enter into an interconnection agreement with the developer which sets forth the obligations of the developer to install all infrastructure needed to accomplish electricity distribution. Most likely this includes the design, construction and maintenance of a substation and transformers to convert the energy for transmission onto the grid.
These installations may be in place for many years. If the utility takes possession of the facility after start-up, they own it and have to maintain it. However, if the opposite holds true and the developer holds that obligation, very often the utility will be looking for some financial guarantee to ensure they will perform maintenance and corrective work for the duration of the interconnection agreement.
Interconnection bonds are underwritten on the same basis as the decommissioning bonds, but with the added risk that failure on the part of the developer to maintain the interconnection may be interpreted to be a side guarantee to the power purchase agreement as well.
How can we help?
First we start to understand your needs after which we bring your needs and our understanding of your business together to bring balance and insight to the situation. Our experience and broad network of surety companies puts us in a unique consultative role to find the best possible solution for your surety requirements. That by itself is valuable.
There isn’t an answer for everything, but if it exists we’ll find it.
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