The early negotiation of an energy services agreement is crucial to both the host company and third-party developer of an on-site cogeneration scheme – indeed, many projects fail to get off the ground when this is not done successfully. Here, Jon Norling discusses the most important issues relevant to the US market.
Both industrial hosts and developers can benefit from outsourcing the ownership and operation of on-site cogeneration. The industrial host (the ‘host’) gets a stable supply of energy without the headaches of operating a facility that may be different from its traditional business line. The developer (termed the ‘owner/operator’) gets the financial benefits of an operating project and an addition to its resource portfolio.
To secure the outsourcing benefit to both parties, however, the host and owner/operator must explicitly address several issues in their contractual arrangements. The essential contract in these deals is often the energy service agreement (ESA), under which an owner/operator of a cogeneration plant provides electricity and thermal generation in exchange for a fee. Great care should be taken when drafting this agreement, in order to ensure that the project can be financed and constructed on time and under budget.
When drawn up properly, energy services agreements can be beneficial for both the industrial host and the owner/operator (All photos: DG Investors, LLC)
This article discusses the most significant financing, regulatory and operational issues that need to be addressed explicitly in an ESA in order to advance a project to a timely commercial operations date. These issues should be addressed at the outset. The sooner they are addressed, the greater the likelihood of a productive, long-term and rewarding relationship between the owner/operator and the host.
ADEQUATE COLLATERAL FOR THE LENDER
The first six issues relate to making the ESA ‘bankable’, meaning the agreement is adequate collateral for the bank or another financial institution providing the money to the owner/operator to develop the cogeneration project (the ‘lender’). Often the lender will want a lot of say in what is contained in the ESA. By recognizing the lender’s concerns early on, the parties lessen the chance of having to renegotiate the ESA, which is generally a heavily negotiated document under the best circumstances. At best, addressing lender concerns after the fact will delay the development of the project. At worst, it will unnecessarily kill the deal. Here are the six issues:
1. Require minimum payments
Typically, a lender will insist that the ESA guarantees minimum payments for energy, that is, payments sufficient to cover the debt service on the loan. The lender wants its position covered even if the project is not operating. While hosts are reluctant to be forced into a situation where they are required to make a payment even if no energy is received, the situation can be alleviated by including in the deal some type of credit support to cover the plant owner’s obligations, such as a letter of credit or a guaranty from a creditworthy entity.
2. Offset payments not allowed
Another problem arises when the host has the unilateral ability under the ESA to offset the amount due for the developer’s failure to provide service. The host should not have the ability to offset the payments it owes, as this may impact the guaranteed source of revenue demanded by the lender. The host’s concerns can be dealt with by a credit facility outside of the ESA, such as a letter of credit or a guaranty.
3. Lockbox or escrow account
An ESA should provide that all payments made under the ESA go into a lockbox controlled by the lender, or into an escrow account. This provision conforms the payment terms of the ESA to the terms of the loan agreement, for the loan agreement will likely require all money received by the borrower to go into an account controlled by the lender. The ESA can provide:
- all payments shall go into the lockbox or escrow account
- financial issues concerning performance shortfalls shall be addressed between the host and the owner of the cogenerator plant without regard to the lockbox or escrow account.
4. Limited termination rights
A host may demand the right to terminate the ESA if there is a breach of the ESA by the owner/operator, or if the owner/operator (or its parent) goes bankrupt. It is understandable why the host would want this termination right, since the alternative is to be saddled with an insolvent counterparty, but the result of including it in the ESA can be a project with no financing.
From a lender’s perspective the ESA is critical to its collateral package, and the lender wants an ESA strong enough to remain in place, notwithstanding the financial condition of the borrower. As with the minimum payment and no offset issues, the termination issue can be worked out for the host via credit support outside of the ESA. In this way both the lender and the host can be accommodated in the event of financial problems with the owner/operator.
5. Step-in rights
Often, both the host and the lender want ‘step-in rights.’ Step-in rights allow a party to take over operation of the plant if the owner/operator defaults. Since host and lender have aligned interests – both want the project to be operating and producing energy – the ESA can provide step-in rights to both host and lender, with the lender’s rights taking first priority.
At a minimum, the lender should have notice of and opportunity to cure the default of the owner/operator before the host exercises its step-in rights. The host should be aware that a lender may want more than the 30-day cure periods typical of ESAs. The lender is a financial institution, not an energy developer, and may require additional time to contract with a party able to cure the default.
6. Lease real estate
A cogeneration plant may have a small footprint and be located on the roof of a structure, but these are not reasons to avoid a lease for the plant, as opposed to a licence. A lease will provide a lender with the assurances it needs that the plant, together with the ESA and the lease, is the ‘total package’ it needs for good collateral.
While a license may be easier for the parties to the ESA (it can be granted in the ESA), a licence can be revoked at will, and a licence does not give the lender the comfort it needs, namely the ability to acquire the leasehold interest, which is often recorded in the county land records, and thus less likely to be set aside in a bankruptcy proceeding. Like the ESA, the Lease Agreement should limit the termination rights of the host.
The lack of a real property interest could prevent the project financing of a cogeneration plant. Indeed, on more than one occasion, the lack of a leasehold interest has killed the financing of a project that was otherwise an ideal candidate for project financing.
In addition to the financing issues, an ESA needs to address the regulatory issues of cogeneration projects. In the United States, cogeneration projects are frequently Qualifying Facilities (QFs) under the Public Utility Regulatory Policies Act of 1978 (PURPA). Maintaining QF compliancy is critical. Where cogeneration projects are also renewable energy projects (i.e., fired with biomass or landfill gas), more issues arise. Finally, local regulatory bodies may attempt to assert jurisdiction over these developments, by asserting that the owner/operator is a public utility. The specific issues in this category are as follows:
7. Maintenance of QF status
For United States projects, the host must adhere to the QF standards under PURPA, and failure to maintain the standard could lead to a default under financing arrangements or the sale of excess generation to a local utility.
A well drafted ESA allowed for the repowering of a mall in Brooklyn
For cogeneration projects, the host will generally have the responsibility to use the thermal energy, which will demonstrate that the facility qualifies: it is a true cogeneration project, where both the electric and thermal output are put to beneficial use. Therefore, the ESA should require the host to warrant that it will take the thermal energy on a take-or-pay basis, thus helping to ensure that the project will continue to meet the thermal requirements under the regulations of the Federal Energy Regulatory Commission.
8. Ownership of environmental attributes
ESAs have historically failed to address the ownership of the environmental attributes of the project or the energy produced with renewable fuels. Today, carbon credits and renewable energy credits have recognized value and can provide a significant additional revenue stream.
Markets for environmental attributes are starting to become more developed, and the ESA should clearly address ownership of environmental attributes and the income effectively realized from credits transfers. Because of the broad nature of environmental attributes, which include renewable energy carbon, sulphur dioxide, and NOx credits, the environmental attribute provision should be broad enough to include additional attributes that may become important in the future.
9. Local jurisdiction
In instances where an owner/operator is providing thermal and electric energy to a facility adjacent to the cogeneration plant, but not necessarily in the same complex, a local regulatory body, such as a public utility commission, may assert jurisdiction over the owner/operator, arguing that the sale of electric energy makes the owner/operator a public utility. The owner/developer must fully understand the regulatory ramifications of the proposed deal structure, and craft language to avoid falling under the jurisdiction of a regulatory body, which can significantly increase transaction costs and derail the project before it even starts.
FUEL PRICE RISK
The last issue is an operational one, and is by no means insignificant:
10. Allow for pass-through of fuel costs
Hosts want price stability for the energy purchased under the ESA, but in the end this can mean an uneconomic project. For example, if the price for electricity is fixed in the ESA, but the owner/operator’s fuel costs vary, the project could go into the red, where payments cannot cover both debt service and operation and maintenance expenses.
Therefore, the ESA should provide that energy prices contain variability factor to cover fuel price risk. Linking electric purchase price to fuel costs will minimize the risk of the project becoming uneconomic due to short-term fluctuations in fuel prices.
While these 10 issues are by no means all of the issues that arise in ESA negotiations or project financings, they are the major ones that should be considered in the term sheet detailing the project. Nothing is more problematic to a deal than attempting to get amendments after the fact; parties may lose credibility and even be viewed with suspicion when previously negotiated terms of the deal begin to change. The reward of each party being fully aware of and addressing the concerns of all the parties comes in the form of a smooth negotiation process and the timely development of the project. The ESA in particular needs to be carefully thought through, so that the lender is happy with it and the host knows its issues have been addressed, if not in the ESA, then in an ancillary document or credit facility.
Jon Norling is a shareholder in the Portland, Oregon office of Lane Powell, PC, US.
Real-life examples of ESA debacles
- In New York, a cogeneration plant could not get project financing because the host would only grant the developer a licence for the plant, rather than a leasehold interest that could be recorded.
- In California, several cogeneration projects had ESAs that guaranteed the host a specific reduction of the utility rates that the host would otherwise pay; all of these projects went belly-up when rocketing natural gas prices rendered the projects uneconomic.
- In Oregon, the public utility commission attempted to prevent the developer of an owner/operator from selling energy to an adjacent electricity plant, claiming that the developer would be a ‘public utility’ serving in a territory previously allocated to another utility.