US energy finance: Tips for the trade of renewables

Author: | Published: 1 Oct 2008
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At present, 29 states and the District of Columbia have adopted renewable energy portfolio standards requiring that utilities within their respective states purchase a specified portion of their energy from renewable resources. The relevant legislation and regulations in most of these states set forth a system of crediting producers of renewable energy with one renewable energy credit (REC) for each megawatt hour of energy produced from renewable resources. Utilities within the state, in turn, must procure a specified number of RECs each year to demonstrate compliance with the applicable renewable energy portfolio standard requirements. The separate sale of RECs allows the value of energy produced from renewable resources to be competitively valued and sold separately from the energy itself. While negotiated power purchase agreements that promise to transfer all of the energy and RECs from a single project to a purchasing utility are not uncommon in these states, the regulatory system that allows the developer to market and sell the power and the REC value of its project separately gives the developer flexibility in maximising the value of the output from its project. Just as important, the option of proceeding in a manner other than a negotiated power purchase agreement gives the developer leverage and a certain degree of bargaining strength opposite the utility if the developer chooses to attempt to negotiate a power purchase agreement.

At present, 29 states and the District of Columbia have adopted renewable energy portfolio standards requiring that utilities within their respective states purchase a specified portion of their energy from renewable resources. The relevant legislation and regulations in most of these states set forth a system of crediting producers of renewable energy with one renewable energy credit (REC) for each megawatt hour of energy produced from renewable resources. Utilities within the state, in turn, must procure a specified number of RECs each year to demonstrate compliance with the applicable renewable energy portfolio standard requirements. The separate sale of RECs allows the value of energy produced from renewable resources to be competitively valued and sold separately from the energy itself. While negotiated power purchase agreements that promise to transfer all of the energy and RECs from a single project to a purchasing utility are not uncommon in these states, the regulatory system that allows the developer to market and sell the power and the REC value of its project separately gives the developer flexibility in maximising the value of the output from its project. Just as important, the option of proceeding in a manner other than a negotiated power purchase agreement gives the developer leverage and a certain degree of bargaining strength opposite the utility if the developer chooses to attempt to negotiate a power purchase agreement.

In California and several other states, the legislation promoting the purchase of renewable energy does not contain a system for the separate valuation or sale of RECs. Legislation in those states typically requires that each of the non-exempted utilities in the state purchase a specified portion of their energy needs from qualified renewable resources. Thus, without a separate trading market or separate valuation of RECs, developers of a project in these states must sell their energy and any value attributed to the fact that the energy comes from renewable resources on a bundled basis to purchasing utilities. Often, because of limits on delivery, the only buyer for the power from the project may be a single utility that may have solicited proposals for renewable energy from numerous developers. If only a single utility is involved, its monopoly position could provide it with an unusual degree of bargaining leverage when it comes to negotiating a power purchase agreement for the energy from a renewable project. When faced with a single potential buyer for both the power and the renewable energy value from the project, the renewable energy developer modifies both its expectations and approach to negotiate the power purchase agreement.

Expectations and approach

In suggesting that the developer must modify its expectations, there is no implication that the developer must resolve itself to a one-sided agreement. A number of factors can influence the respective bargaining power of the parties, even in states requiring the bundled sale of energy and renewable value. For instance, in many states, including California, it is not a foregone conclusion that a project will only have a single power buyer who will be willing to pay an additional amount for the renewable energy value. In the Southern California Edison service territory, for example, while Southern California Edison is the only utility subject to California's renewable portfolio requirements of 20% by 2010, other municipal utilities, such as the Los Angeles Department of Water and Power, have internal requirements to purchase renewable energy and can serve as competition for Southern California Edison. In other states, electric cooperatives and others may have elected to join the market for renewable energy. What is not available to the developer, unlike states with tradable RECs, is the option of not entering into a power purchase agreement and instead selling the power into the market at market prices, with or without some sort of a price hedge, and selling the renewable energy value separately. In California and similar states, the option is usually to negotiate a power purchase agreement with a purchasing utility or not build the project. This limited option gives the purchaser of the power a distinct negotiating advantage and developers are cautioned not to expect the same flexibility of power purchase agreement terms that one might see in states where competitive REC sales and the option of open market sales of power exist.

In suggesting that the developer must modify its expectations, there is no implication that the developer must resolve itself to a one-sided agreement. A number of factors can influence the respective bargaining power of the parties, even in states requiring the bundled sale of energy and renewable value. For instance, in many states, including California, it is not a foregone conclusion that a project will only have a single power buyer who will be willing to pay an additional amount for the renewable energy value. In the Southern California Edison service territory, for example, while Southern California Edison is the only utility subject to California's renewable portfolio requirements of 20% by 2010, other municipal utilities, such as the Los Angeles Department of Water and Power, have internal requirements to purchase renewable energy and can serve as competition for Southern California Edison. In other states, electric cooperatives and others may have elected to join the market for renewable energy. What is not available to the developer, unlike states with tradable RECs, is the option of not entering into a power purchase agreement and instead selling the power into the market at market prices, with or without some sort of a price hedge, and selling the renewable energy value separately. In California and similar states, the option is usually to negotiate a power purchase agreement with a purchasing utility or not build the project. This limited option gives the purchaser of the power a distinct negotiating advantage and developers are cautioned not to expect the same flexibility of power purchase agreement terms that one might see in states where competitive REC sales and the option of open market sales of power exist.

When a developer is faced with the limited choice of agreeing to the terms set forth by a single power purchaser or electing not to build the project, the developer should consider altering its strategy to be more selective about which provisions in the power purchase agreement need to be modified. In any form of power purchase agreement, there are dozens of provisions that can be the subject of negotiations, including the product to be sold, completion obligations, conditions precedent to delivery, construction performance security, operational security, project liens, pricing, test energy, production guarantees, mechanical availability, lender consent provisions, credit issues, scheduling, regulatory changes and a number of others. It is unlikely that, if a utility has a very strong negotiating position, it will have the patience to negotiate each item of the power purchase agreement that the developer might like to negotiate. The developer will need to decide which items in the power purchase agreement will provide a real benefit to the utility and are fair to both parties, and which items are merely the product of the utility's unique bargaining position and require further negotiation.

Target provisions

In deciding which provisions of the power purchase agreement should be targeted for revision, developers should keep in mind that utilities are under increasing pressure from both the public and regulators to expand the amount of renewable energy they purchase. Thus, an opportunity should exist to permit a successful power purchase agreement to be concluded if the parties focus on a limited number of items of critical importance to the developer and that should be of marginal importance to the utility, as follows.

In deciding which provisions of the power purchase agreement should be targeted for revision, developers should keep in mind that utilities are under increasing pressure from both the public and regulators to expand the amount of renewable energy they purchase. Thus, an opportunity should exist to permit a successful power purchase agreement to be concluded if the parties focus on a limited number of items of critical importance to the developer and that should be of marginal importance to the utility, as follows.

Conditions precedent

The first provisions of the power purchase agreement that the developer should review are the conditions precedent to the developer's obligations to complete the project and sell power to the utility. In many cases in which renewable energy developers bid for power purchase agreements, the projects for which the bids are made are two to three years, or more, from development. Many factors, including obtaining the required permits, securing transmission within certain cost parameters, obtaining public utility commission approval, and a number of others, may remain outside of the control of the developer. The price of wind turbine equipment and construction costs remaining stable (within some upward range) may also have been part of the developer's pricing assumptions. All of these items are fairly to be considered as conditions that, if not satisfied, could allow for an extension of time for performance or, possibly, the termination of the power purchase agreement and the return of the project completion security. Utilities contracting for power from future projects are not unaware of these issues and are aware that some flexibility in this area will be required to secure future projects.

The first provisions of the power purchase agreement that the developer should review are the conditions precedent to the developer's obligations to complete the project and sell power to the utility. In many cases in which renewable energy developers bid for power purchase agreements, the projects for which the bids are made are two to three years, or more, from development. Many factors, including obtaining the required permits, securing transmission within certain cost parameters, obtaining public utility commission approval, and a number of others, may remain outside of the control of the developer. The price of wind turbine equipment and construction costs remaining stable (within some upward range) may also have been part of the developer's pricing assumptions. All of these items are fairly to be considered as conditions that, if not satisfied, could allow for an extension of time for performance or, possibly, the termination of the power purchase agreement and the return of the project completion security. Utilities contracting for power from future projects are not unaware of these issues and are aware that some flexibility in this area will be required to secure future projects.

Project security

Utilities typically require security at two separate points in the life of a renewable project: (i) after signing but before commercial operation of the project; and (ii) after commercial operation of the project through to the end of the term of the power purchase agreement. Some utilities have also required the posting of a deposit or a letter of credit upon notification that the bidder has been selected for further negotiation for a power purchase agreement, but these deposits are generally refundable if final agreement is not reached on a power purchase agreement.

Utilities typically require security at two separate points in the life of a renewable project: (i) after signing but before commercial operation of the project; and (ii) after commercial operation of the project through to the end of the term of the power purchase agreement. Some utilities have also required the posting of a deposit or a letter of credit upon notification that the bidder has been selected for further negotiation for a power purchase agreement, but these deposits are generally refundable if final agreement is not reached on a power purchase agreement.

The deposit or other security required at signing in order to ensure that the party contracting to sell power to the utility completes the project is generally quite modest on a per megawatt basis but could be substantial if a large project is involved. Developers should focus not only on the amount of the security but also on the timing and type of security. The amount of security should be sufficient to cover the damages of the utility if the developer fails to proceed with and complete the project following the satisfaction of the conditions precedent to development. The developer may also want to consider not having the security due until after the public utility commission approves the power purchase agreement or after certain of the conditions precedent have occurred. The developer may also want to suggest that the security be deposited in stages for large projects that will be built in phases over a number of years.

The deposit or other security required to be posted once the renewable energy project reaches commercial operation has typically been much more substantial and can involve letters of credit, cash deposits, guaranties from parent companies of the project owner and liens on the project assets. In general, this security is posted to assure the utility that the project owner will not divert the energy to a party other than the utility and that the project owner will meet certain minimum output or availability guarantees. Post-commercial operation security has long been viewed by developers as an item that increases the cost of producing power but that seems to provide only marginal benefit to the utility. Significant security may make sense when power is being actively traded and future deliveries contracted. However, in the renewable space, it would be very rare for a project owner to divert power from one buyer to another, at least for very long. Furthermore, as an intermittent resource in which nearly all the costs of the projects are in the capital costs, ceasing to fully operate the project and missing annual production targets would be very rare. Thus, the amount and type of security ought to be, and often is, the subject of negotiation.

Production and availability guarantees

It has become more common in recent years for the purchasing utility to require some sort of an output guaranty covering each annual or two-year period of the power purchase agreement. These guarantees either promise a set minimum number of megawatt hours per year (usually tied to a percentage of the P-50 or P-99 estimates) or require that the equipment in the project remains available and operating a certain percentage of the time (85%). The damages for failing to comply with these provisions will either be a specified sum per megawatt hour of shortfall or, more commonly, the actual difference in cost between the utility's cost of obtaining replacement green energy and the price set forth in the power purchase agreement.

It has become more common in recent years for the purchasing utility to require some sort of an output guaranty covering each annual or two-year period of the power purchase agreement. These guarantees either promise a set minimum number of megawatt hours per year (usually tied to a percentage of the P-50 or P-99 estimates) or require that the equipment in the project remains available and operating a certain percentage of the time (85%). The damages for failing to comply with these provisions will either be a specified sum per megawatt hour of shortfall or, more commonly, the actual difference in cost between the utility's cost of obtaining replacement green energy and the price set forth in the power purchase agreement.

When negotiating these types of provisions, the developer should consider the quality of its wind studies, solar analyses or other bases for projecting output. If such reports are able to predict a P-99 output for the site, the developer may want to limit its production guaranty to such estimated output, discounted by a predicted equipment availability factor of 90% or 95% and further discounted by an additional margin of error. If reliable resource data is not available, the developer should consider offering a guaranty only as a percentage of availability of the equipment. As any equipment outage is likely to be short-lived, it may be advisable to attempt to base the output or availability guaranty on a two-year period rather than on an annual period. The developer should also seek to have force majeure events, transmission outages or losses and acts by the power purchaser to be counted as deemed output or available hours in any calculation. Further, rather than monetary damages, the developer may want to consider an obligation to take extraordinary efforts to repair any equipment that is having availability or performance issues. Finally, the developer should consider whether a limit on overall liability should also be included as part of this type of provision.

Credit provisions

Not so long ago, California's two largest investor-owned utilities faced a credit crisis. Pacific Gas & Electric filed for bankruptcy and Southern California Edison suspended payment to a number of independent power producers. While many of the factors that led to that crisis have been corrected, the incident highlights the importance of including credit requirements in power purchase agreements.

Not so long ago, California's two largest investor-owned utilities faced a credit crisis. Pacific Gas & Electric filed for bankruptcy and Southern California Edison suspended payment to a number of independent power producers. While many of the factors that led to that crisis have been corrected, the incident highlights the importance of including credit requirements in power purchase agreements.

In its simplest form, a credit provision ought to state if the power buyer's credit is downgraded by one of the big credit rating agencies or if its credit rating is otherwise put on watch by those agencies, which will result in a default under the power purchase agreement. This default would allow the owner of the project to cease power deliveries and/or terminate the agreement. However, most utilities remain very reluctant to include such a provision in their power purchase agreements.

Typically, the project owner is paid for the power that it delivers in any month within 20 or 30 days after month end. If a credit problem exists with the utility, the project owner could be exposed to potentially millions of dollars in delivered power for which it might not be paid and, therefore, would need a remedy. If the utility will not agree to the standard remedy of default and suspension or termination, the developer should consider other remedies. The developer may want to consider requiring that an advance deposit or letter of credit be posted in the event of a credit downgrade. Alternatively, the payment schedule for power may be accelerated so that payment is made in shorter increments.

Regulatory risk

The risk that the laws and regulations relating to the production, delivery or purchase of renewable power may change after the power purchase agreement is signed is a risk that most project developers cannot bear. Project developers will typically finance their project on the basis of a relative certain flow of revenue that will come from the power purchaser. If the power purchase is able to avoid its obligation to purchase power because the law pertaining to the requirement to purchase renewable energy changes, it would be very difficult, if not impossible, for the developer to obtain financing for its project. Thus, with limited exception, it is rare to see developers taking the risk that laws or regulations may change.

The risk that the laws and regulations relating to the production, delivery or purchase of renewable power may change after the power purchase agreement is signed is a risk that most project developers cannot bear. Project developers will typically finance their project on the basis of a relative certain flow of revenue that will come from the power purchaser. If the power purchase is able to avoid its obligation to purchase power because the law pertaining to the requirement to purchase renewable energy changes, it would be very difficult, if not impossible, for the developer to obtain financing for its project. Thus, with limited exception, it is rare to see developers taking the risk that laws or regulations may change.

Two exceptions to this general rule pertain to the federal production tax credit and market design regulations. In most power purchase agreements for renewable energy, the price agreed upon assumes the applicable federal tax credit (the production tax for wind and other technologies and the federal investment tax credit for solar energy). Typically, especially in power purchase agreements that contemplate project completion of all or a portion of the project several years after signing, the availability of tax credits will be a condition precedent to the obligations of the developer to complete the project and sell power.

A more difficult question arises if the regulations pertaining to the delivery of energy change or there is a change in the market design for a particular area. For example, if the current regulations provide that power is to be delivered to the purchaser at a specific point of the delivery, but regulations or a change in the design of the electricity markets now require that such energy be delivered to a new point, who should bear that cost? Power purchasers have differed in their approach to this. From the developer's perspective, as with any project that is project financed, the project is not set up to be able to accommodate significant new costs. Nonetheless, some power purchasers with strong market power may also refuse to accept this risk that, in essence, could increase the cost to the purchaser of the energy that they have agreed to accept. If a power purchaser refuses to accept any regulatory risk, or if the risk is somehow split, the possible cost of regulatory change must be built into the price of the energy from inception.

What's next?

As the rate of growth of renewable energy projects has increased in recent years, so have the size of renewable energy projects. We have recently seen a number of projects announced that will be in the thousands of megawatts and will be installed over a number of years. In some cases, purchasing utilities have or will reach agreement on the sale and delivery of output from the future phases of these so-called megaprojects. These projects, which may be completed several years in the future, present a number of new issues. The most challenging of these issues is how to price power from a project that will be built at an unknown cost several years in the future.

As the rate of growth of renewable energy projects has increased in recent years, so have the size of renewable energy projects. We have recently seen a number of projects announced that will be in the thousands of megawatts and will be installed over a number of years. In some cases, purchasing utilities have or will reach agreement on the sale and delivery of output from the future phases of these so-called megaprojects. These projects, which may be completed several years in the future, present a number of new issues. The most challenging of these issues is how to price power from a project that will be built at an unknown cost several years in the future.

The pricing dilemma can be addressed by indexing the price to the cost of future construction of the project. This can be a little tricky, but workable if the utility and the state public utility commission find the approach reasonable. The second approach is to tie the price to an average of future renewable energy prices. In California, for example, the State Public Utilities Commission each year sets the Market Price Referent, which suggests an average price for renewable energy contracts, below which the Public Utilities Commission will likely approve a proposed purchase of renewable energy by a utility.

Obviously, pricing will not be the only issue that will occur in power purchase agreements as the megaprojects become more common. Other issues will likely include development covenants and restrictions on the sale of power from future phases to others, utility purchase, participation rights and much more complicated security arrangements.

By Edward W Zaelke of Chadbourne & Parke

Author biography

Edward W Zaelke

Chadbourne & Parke LLP

Tel: 213 892 2012
Email: ezaelke@chadbourne.com

Edward Zaelke, managing partner in the Los Angeles office of Chadbourne & Parke LLP, focuses his practice on project development and finance, with a particular emphasis on representing companies engaged in the development, finance and operation of wind power and other alternative energy projects. Edward's experience extends to all elements of alternative energy development, including power purchase agreements, siting and other real property issues, governmental approvals, equipment purchase and sale agreements, construction and EPC contracts and equity and debt financing.

Edward is the former president of the American Wind Energy Association and has been a board member of the American Wind Energy Association since 2002. He holds a BA from California State University, Long Beach and a JD from the University of California, Los Angeles.