Allocation Of Risk In Power Purchase Agreements For On-Site Power
It is important that all parties involved understand their respective risks.
Whether to achieve enhanced reliability, to utilize renewable resources, to make use of cogeneration in response to natural gas prices, or to take advantage of tax and other financial incentives, facility owners are increasingly installing on-site generation to provide power. On-site generation can include cogeneration, solar and wind power, fuel cells, and other technologies that produce electric power.
A power purchase agreement (PPA) is an important practical and financial tool for acquiring on-site generation. A PPA permits the facility owner to outsource the responsibility for designing, financing, procuring, constructing, permitting, operating, maintaining and, if applicable, obtaining fuel for the on-site generation facility. In consideration, the owner agrees to purchase the energy production and provide a site by a lease or an irrevocable license for the use of the seller\provider on the property of the owner.
Typical sellers might include solar developers, companies that specialize in providing on-site cogeneration, and energy services companies. Typical buyers could include commercial office buildings, data centers, production facilities, or large residential buildings.
It is important that the parties to a PPA for on-site energy production have an understanding of the respective risks of the parties and knowledge of how best to mitigate those risks by means of contractual provisions and practical steps.
Each party to a PPA tends to focus primarily on the risk of default by the other party. However, inappropriate or insufficiently considered provisions in a PPA unnecessarily increase the risk of default by either party. This column reviews common risks and discusses considerations to bear in mind so as to avoid these risks. Typical common risks for both parties include a counterparty’s non-performance, unfavorable pricing, force majeure events, and credit issues.
Seller’s risks can include, among others:
- Problems with fuel availability, transportation, and commodity prices
- Contractor/vendor failure to perform and failure to obtain necessary permits or approvals
- Excessive costs of equipment, installation, or operation
- Issues with fuel availability, transportation, and pricing, if applicable
- The payment stream proves to be insufficient to cover seller’s debt service, O&M, supply, transportation of fuel, and other costs, such as legal compliance, overhead, and contingencies
- Possibility of buyer’s transfer or sale of the facility/building
Buyer’s risks can include, among others:
- System proves unreliable
- Failure to obtain projected tax and other financial incentives
- Tariff issues – the possibility of being obliged to take standby utility electric service under a classification that imposes high costs in the event of an on-site system outage during peak demand periods
- Power quality problems
- Being subject to a take-or-pay quantity requirement that exceeds buyer’s actual needs
The parties must address the following issues when addressing risk mitigation strategies.
Buyer analysis of its energy requirements. At the beginning of the contracting process, the buyer (or his consultant) should audit and analyze his own energy usage characteristics (including future plans that will impact energy usage), reduce these to an accurate, written description, and input the information into an electronic spreadsheet. This is an important stepping stone for contracting with sellers and avoiding unanticipated problems in meeting the requirements of PPAs. It also can help to avoid the all-too-common issue of one hand not knowing what the other is doing within organizations. The written materials and spreadsheet can help to inform both sides of those negotiating the PPA.
PPA take-or-pay covenant. Under a take-or-pay covenant, a seller agrees to supply and the buyer agrees to purchase or pay for not less than set amounts of electric commodity in kWhs and power in kW (and, if applicable, thermal energy). In order to protect itself, a buyer should take care to reasonably project its demand, taking into account all relevant considerations. The take-or-pay price can be:
- Fixed plus fuel adjustment
- As otherwise agreed
In order to claim a “pay,” when the buyer has not “taken” the electricity, seller must have available capacity to provide the electric service in order to claim the pay.
PPA reliability and performance standards. The PPA should cover total, permitted scheduled outage times for maintenance etc., and specify when these shall occur. An addition, specified quantity of unscheduled outage time may be permitted during the first year(s) of operation for working out bugs. Reliability and performance standards must be such that seller may operate within reasonable margins of the expected availability of the equipment and typical outage times. Buyer’s remedies for deficient reliability should be clear and readily exercisable.
How should non-performance provisions be limited? Each party should closely examine the other party’s contractual justifications for non-performance. What justifiable reasons are there for either seller’s or buyer’s non-performance under the PPA? Does the seller have the right to suspend delivery in the event of supply-related problems? Do justifying circumstances include prices above a certain level as determined by a referenced index? What rights does a buyer have to suspend its take-or-pay obligations? Each party will seek to keep the other party’s non-performance excuses to a minimum. If either party seeks expansive non-performance excuses, the other party is likely to seek more favorable pricing or seek favorable revisions to other provisions.
Cover remedy. For individual events of unjustified non-performance by the seller which do not demonstrate seller’s overall inability to perform (e.g., the seller does not deliver electricity in a single instance, when promised, under an otherwise favorable contract and seller’s non-performance is not justified under the contract), the buyer should bargain for the right to immediately secure power from another source (including, of course, the distributing utility) and charge any overage in price back to the seller for power not provided by the seller. More specifically, buyer’s cover remedy should require seller, within a set time period following buyer’s demand for reimbursement, to pay buyer for an unfavorable pricing variation (increase over the PPA price) that buyer has to pay to obtain the energy that seller failed to provide.
Metering and measurement and verification standards. M&V standards, as applicable, must be reasonable and be clearly set forth in the PPA or availability guarantee. The relevant provision must show how the on-site generating system’s availability and power production (and, if applicable, thermal energy) is to be determined. Metering types and locations should be mutually agreed upon and third-party reading should be considered.
Financial incentives and tax benefits. The parties should agree on allocation of tax and other incentives, including “green attributes,” to the extent that these can be allocated. Uncertainty as to how incentives will be allocated would be a negative to any lender and likely give rise to disputes. The seller (as owner of the system) should be entitled to retain tax benefits relating to ownership and operation. Any “buyout” price should also take into account any tax benefits and credits.
Knowing and complying with legal requirements. It is important to understand the laws and regulations that may impact on-site power sales. For example, will the seller be deemed a “utility” by virtue of his providing on-site power? If so, how will utility status impact the transaction? Regulations can include specific provisions, which must be included in energy sales contracts with retail customers covering areas such as billing, customer deposits, obtaining and protection of confidential information, buyer rights and obligations, termination, switching, and complaints.
What is the application of the Uniform Commercial Code (UCC) and which UCC rights should be referenced in the purchase agreement? The parties should determine whether the applicable state UCC is applicable to the sales transaction. The UCC may or may not be applicable to sales of electricity at distribution-level voltages in the buyer’s state (and the laws of individual states should be checked). Whether or not the UCC is applicable, the PPA should provide for certain UCC remedies such as giving each party the right to ask the other for reasonable, adequate assurances that the other party can perform the agreement. In the event that adequate assurance of performance is not forthcoming, the requesting party should have the right to terminate the agreement. This is important if a party has reason to believe that the other party may not be financially able to perform the contract.
What are appropriate dispute resolution and default provisions? A PPA should allow for cure of minor breaches and not allow them to be characterized as events of default. A PPA should also allow for continued service and payment of undisputed amounts while providing for dispute resolution relating to disputed amounts. However, it is equally important that serious problems (particularly those which imperil long-term performance) should permit the non-defaulting party to promptly end the contractual relationship. The parties should review any default provisions carefully. In addition to the expected defaults for unjustified failure to supply or pay, what are the other grounds for default? What, if any, are the cure provisions? There is no one default provision which is appropriate in every situation. These must be viewed in light of the terms of the entire PPA.
This column has looked at PPAs from the respective viewpoints of both sellers and buyers. Like a well-negotiated dispute settlement, an appropriate PPA is one with which each party obtains some but not all of the points on its wish list; neither party is entirely satisfied; and each party has ample contractual motivation to perform its obligations.
This column discusses certain, but not all, of the important considerations for parties to consider when negotiating and entering into PPAs. This column, however, should not be considered specific legal advice and readers seeking advice should consult legal counsel having experience with PPAs and on-site generation.