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By Lee M. Goodwin
Thelen LLP
In
1897, U.S. newspapers announced the shocking news that Mark
Twain had died. Twain, very much alive and residing in England,
fired off a telegram to the Associated Press saying that
"The reports of my death are greatly exaggerated."
A
hundred years later, articles began to appear in the power
industry trade press heralding the death of the long-term
power purchase agreement. Since the passage of PURPA in
1978, long-term contracts have been the mainstay of the
U.S. independent power industry. The contracts were critical
to the project financing of numerous power projects sponsored
by entrepreneurial but undercapitalized developers by enabling
the developer to support the financing, in part, on the
stronger credit rating of the power purchaser.
However,
starting in the latter half of the 1990s, industry observers
began to predict that in the future, there would be no long-term
contractual commitments between power purchasers and project
owners. Instead, they said, all power projects would be
built as merchant plants, relying on market forces rather
than long-term commitments to ensure the financial success
of the project. This trend was expected to accompany the
decline in independent project developers and the concentration
of the industry into heavily capitalized, large-scale developers
that could more easily bear the risks of the competitive
power market. The U.S. electric system was expected to go
the way of most international systems, where long-term contractual
commitments virtually have disappeared in favor of spot
market sales at marginal cost prices.
However,
reports of the death of the long-term power contract also
appear to have been greatly exaggerated. Instead, the long-term
power contract is alive and well, and continues to play
an important role in the strategic planning of a number
of leading power industry players. For example, at a recent
conference, a spokesman for one of the top independent power
developers indicated that his company intends to commit
as much as 65 percent of the output of its power projects
to long-term contract (corresponding to the percentage of
its corporate financing derived from long-term debt) while
only selling 35 percent of the output on the spot market.
One
aspect of long-term power sales has changed since the early
days of the independent power industry. Now, many long-term
contracts are in the form of "tolling agreements"
rather than power purchase agreements. Tolling agreements
may appear to be a recent phenomenon, but they have been
around for at least a decade in one form or another. Tolling
agreements are based on power purchase agreements, and many
of their principal legal provisions are identical.
The
main difference between a tolling agreement and a power
purchase agreement is that in a power purchase agreement,
the project owner is responsible for fuel supply and assumes
fuel availability and price risk. In a tolling agreement,
the buyer also is the fuel supplier, and instead of buying
kilowatt hours, the buyer, in effect, buys the service of
converting fuel into electric energy. For this reason, early
tolling agreements were called "conversion agreements."
The project owner still sells capacity and ancillary services.
However, instead of a sale of goods, a tolling agreement
is more in the nature of a service contract in which the
project owner sells fuel conversion services. The term "tolling
agreement" derives from the fact that the project owner
is charging the purchaser a "toll" for allowing
the purchaser's fuel to pass through the owner's project.
There
are several reasons for the popularity of tolling agreements.
With increasing convergence between the electric and gas
industries, many power purchasers now have access to gas
resources. Even those that do not have their own gas resources
often are interested in controlling the fuel price risk,
which usually is the largest and most volatile price factor
in a power project.
Despite
these differences, tolling agreements satisfy the primary
reason for long-term contracts because they provide a dependable
revenue stream for the project owner that can support project
finance and other financing commitments. In fact, tolling
agreements may be better from a financing perspective because
they involve even less risk than traditional power purchase
agreements because the owner does not bear the risk of fuel
price, availability or transportation.
Many
of the key business issues in power purchase agreements
and tolling agreements are the same. However, the difference
in character between power purchase agreements and tolling
agreements means that some legal issues take on a new spin.
Force
Majeure. The scope of the force majeure excuse
for fuel availability always is an important issue in power
contracts. In many cases, under both power purchase agreements
and tolling agreements, the party that is not responsible
for obtaining fuel will not accept unavailability of fuel
as a force majeure unless it could not have been avoided
by having contracted for firm fuel supply and transportation.
In tolling agreements, fuel-related force majeure takes
on a special importance because if the inability to obtain
fuel qualifies as a buyer force majeure, it could affect
the payment stream unless the buyer's payment obligations
continue during a buyer force majeure. For this reason,
many sellers insist that capacity payments continue despite
a force majeure affecting the buyer's ability to obtain
or deliver fuel to the project and despite other buyer force
majeure events, such as electric transmission interruptions
occurring downstream from the point of delivery for electricity.
Fuel
Use. In traditional power purchase agreements,
the buyer largely was unconcerned with the heat rate of
the project (i.e., the amount of energy it uses to produce
electric energy) so long as output was delivered at the
level contracted for. However, in a tolling agreement, the
buyer has a direct interest in the efficiency of the project
because if efficiency declines, the buyer would have to
supply more fuel to get the same level of output. Accordingly,
the seller under a tolling agreement typically promises
to maintain a specified heat rate at the project and to
make the buyer whole for any increased fuel cost resulting
from lower-than-promised efficiency. However, sellers should
receive a corresponding benefit for greater efficiency because
that will translate into fuel savings for the buyer.
Availability.
Although not unique to tolling agreements, availability
is an increasing issue in all power-related transactions.
In the early days of the independent power industry, sellers
typically were paid a flat rate regardless of when the power
was delivered so there was little incentive to maintain
seasonal project availability. However, with the advent
of spot-market pricing, buyers are insisting that sellers
guarantee the availability of the project, particularly
during seasonal peak periods. Summer availability guarantees
as high as 98 percent are not unusual. Sellers must be sure
that they can control as many circumstances that could lead
to unavailability of the project as possible. In particular,
sellers should ensure that the failure of properly maintained
equipment qualifies as a force majeure and does not affect
the calculation of the project's availability. Sellers also
should ensure that a failure of fuel deliveries or transmission
service will not count against availability.
The
magnitude of liquidated damages for failure to maintain
availability also are an issue. Commonly, liquidated damages
are set as a percentage of the capacity payments paid for
the period involved. Sellers and buyers should ensure that
the contract is clear regarding what is and is not covered
by any liquidated damages for unavailability. In particular,
the contract should state whether liquidated damages are
the buyer's sole remedy for failure to deliver or to be
available to deliver energy or whether the buyer also will
be entitled to "cover" damages in the event that
the seller is unable to respond to a dispatch request. Cover
damages are the difference between what would have been
paid under the agreement and what the buyer has to pay a
third party for electric energy the seller should have delivered.
Particularly in today's volatile power markets, cover costs
during periods of particularly high demand could be huge
and vastly out of proportion to the compensation the seller
would receive for delivering the same power under the agreement.
When the buyer receives most of the benefit from the sale
of power produced by the project during periods of high
demand, it may not be appropriate to expect the seller to
bear the heavier economic burden, driven largely by market
conditions, in the event of non-performance.
Wheeling
and Interconnection. Arranging for the interconnection
of a project with the local utility and the wheeling of
the project's power to the ultimate purchaser are two issues
that must be addressed in any agreement when the buyer is
not the interconnected utility (and, in the case of interconnection,
even with a buyer that is the interconnected utility). Usually,
this requires separate agreements with the utility that
will provide the service, with sellers usually being responsible
for the interconnection agreement, and buyers usually being
responsible for the wheeling agreement. However, the ability
to contract for such service is not something that either
party to a tolling agreement should take for granted, even
in the face of increasingly open access. Several recent
projects have been held up as these seemingly ministerial
agreements are worked out, leading one major independent
power producer to observe at a recent conference that interconnection
issues may be some of the most difficult issues to manage
in the future. In the face of the uncertainties associated
with these third-party arrangements, sellers should ensure
that a delay in securing a wheeling or other agreement that
the buyer is responsible for obtaining will not delay the
commencement of payments under the tolling agreement.
Security.
Security for the seller's performance always has been
an issue in power transactions because project owners frequently
are special purpose companies with few assets other than
the project itself. Particularly during the development
phase, when the project company may have almost no assets
at the outset, buyers usually insist on some performance
security, such as a letter of credit or a guarantee from
a creditworthy parent. Some purchasers insist on security
during the performance phase as well. Buyers sometimes ask
for a subordinated lien on the project assets in addition
to or in lieu of a letter of credit or a guarantee, but
sellers usually are reluctant to agree to a subordinated
lien because it can complicate project financing.
In
the new deregulated power industry, security is becoming
a concern for sellers, as well. Customers for tolling services
often are not as creditworthy as the vertically integrated
utilities that were the power customers in the early days
of the independent power industry. Even the power marketing
arm of a well-established utility may be a thinly capitalized
subsidiary with a credit rating comparable to an independent
power marketer. Accordingly, sellers often insist on security
from buyers similar in scope to the security that buyers
historically sought from sellers. Even if the buyer is creditworthy
when the tolling agreement is signed, it may be prudent
to include provisions providing for security in the event
that the buyer's credit rating falls below a specified level.
Moreover, even if the buyer is an integrated utility with
substantial assets and an investment grade credit rating,
in light of the rapid pace of change in the utility sector,
sellers may want to include provision for security in the
event that the buyer is split up or sells off significant
assets.
Change
in Law. Historically, project owners have not
felt the need for protection against change in law for domestic
projects. This stems in large part from the relative stability
of the U.S. legal system. However, change-in-law protection
became a staple of international power projects, and with
the introduction of competition to the domestic power market,
project owners have begun to focus on who should bear the
risk of increased costs due to changes in law, such as increased
environmental burdens or tax law changes. While no uniform
approach has emerged, many sellers argue, and many buyers
have agreed, that under market-based rates, increased costs
due to changes in law or other factors will be reflected
in power prices and ultimately will flow through to customers.
Accordingly, change-in-law protection for sellers is becoming
more common for domestic power projects.
Environmental
Consequences. It also is becoming increasingly
common for buyers under tolling agreements to ask the seller
for indemnification in the event that the purchaser is held
liable for environmental problems at the seller's project.
This apparently stems from some recent cases in the chemical
industry in which major chemical companies were held liable
for environmental problems at facilities owned by thinly
capitalized processing companies that processed chemicals
for larger companies under tolling arrangements. While this
is an unusual issue in the power industry, it should not
be a major concern for project owners because the project
owner still controls most of the factors that can give rise
to environmental liability on the part of the power purchaser.
Conclusion.
Tolling agreements are playing a larger and larger
role in the domestic power industry. This growth will continue
because tolling agreements enable the buyer to manage an
element of price risk that it usually cannot manage under
a conventional power purchase agreement while continuing
to provide the kind of long-term certainty that sellers
need to support debt and equity commitments. However, careful
attention to the unique legal issues under tolling agreements
is necessary to ensure that all parties truly receive the
benefits that they expect from these increasingly popular
forms of agreement.
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For more information about the issues covered in this report, please contact Lee M. Goodwin in our Washington, D.C. office at 202-508-4346 or lgoodwin@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
©2001 Thelen LLP
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