Current Legal Issues Relating to the Development and Financing of Wind Power Projects
As public concerns grow as to both the adequacy of oil reserves and environmental issues generally, wind power has become an increasing attractive source of energy production. The number of Canadian wind power projects has grown over the last few years, and all indications are that they will continue to do so.
Developing a new wind farm is not, however, a simple task, particularly where the wind farm is financed by highly leveraged, limited recourse debt.
In such a financing, lenders are providing financing against an asset yet to be built, a wind farm, on a limited recourse basis. Essentially, the lenders are lending against cash flow that will result from the generation of electricity sold to a purchaser (usually a provincial utility) under a fixed price power purchase agreement (‘PPA’). Typically, lenders will not lend against green credits, as these are too conjectural from a revenue point of view, although this may change in the future. Merchant wind farms, that is wind farms which do not have a fixed price PPA but, rather, sell power into the spot market, may also be the subject of limited recourse financing, provided that the lenders receive adequate assurances regarding the market in question and relative certainty regarding projected revenues.
In limited recourse financing, the lenders can generally only look to the assets of the wind farm to support the loan (their recourse is "limited" to such assets), not the sponsors or equity investors standing behind the project. Any flaws in the wind farm assets will impair the value of the wind farm as collateral for such loans. The term ‘assets’ here includes, in addition to the physical assets constituting the wind farm, key project contracts such as the PPA, turbine supply agreements, warranty agreements and construction agreements, because the value of the physical asset may be extremely limited without the benefit of such agreements.
Another critical asset, the most important of all, is the wind resource, which must be carefully assessed and analysed having regard to appropriate probability factors. The success or failure of a wind farm is driven more by accurate wind resource assessment than any other factor.
The process of due diligence (legal, technical, regulatory and environmental) enables the lenders to identify and assess risks associated with the particular wind project. Ideally, lenders must be satisfied that all material risks have been identified and hedged or mitigated (or are otherwise determined to be acceptable). This process will complement the representations and warranties that will be set out in the credit agreement between the lenders and the developer.
Lenders will typically have a lower risk tolerance for flaws in the wind farm assets as compared to the developer and equity investors. These players, in turn, have a very different risk/reward profile than the lenders and are willing to take on certain risks that the lenders are not. Accordingly, it is often the lenders, and not the developer, who drive many of the substantive issues that need to be resolved in the course of negotiating key project agreements.
One of the challenges for a developer is the need to settle major project agreements (such as the PPA and turbine supply agreements) before it selects the lenders for the project. What if the lenders require amendments? What if the counterparty is not prepared to entertain any changes? Meeting this challenge is largely a question of managing expectations. Developers should be aware of the sensitivities of the lenders, given their lower risk tolerance generally, and try to address their concerns. Where lenders have not yet been chosen, this can be a challenge, though prospective lenders and their legal counsel are often willing to provide some feedback even though final selection has not yet occurred. Where lenders have been selected, timely input from them before agreements have been settled is essential.
Counterparties are also part of this challenge. They need to realize that the dynamics of settling an agreement for a project that will be project financed will be more complicated than one which is all equity financed. Arguments made by them on the strength of precedent transactions that were not project financed will carry little weight with the developer and its lenders. And, if they settle an agreement without lender input, they should not be surprised when the developer is forced to revisit issues at the insistence of the lenders. At the end of the day, it is necessary to ensure that such agreements meet a "financeable" standard; ignoring lender concerns may impede financing, and therefore the development of the project, or result in a financing offered on less advantageous terms to the developer.
Equity and Subordinated Debt
Generally equity and subordinated debt will be advanced against construction costs prior to the advances of the senior lenders. Subordinated debt will need to be fully subordinated by an intercreditor agreement to the senior debt with appropriate standstill provisions. In my experience, such agreements can be surprisingly difficult to settle on a timely basis and should not be left too late in the process on the premise that such "internal" documents can be settled quickly and without too much fuss.
Power Purchase Agreement
The power purchase agreement is a key agreement in the development of a wind power project. As pointed out above, this is typically the major, if not sole, source of revenue for the project. Some of the issues which need to be considered in connection with settling such agreements are the following:
- Term and Fixed Price: Lenders will want to see a PPA that has a term that exceeds the term of the loan provided. The developer will want to see a PPA term that is consistent with the design life of the wind turbines of the wind farm, typically, on the order of 20 years or more. Prices for power under such agreements are typically fixed although developers like to see an inflation factor adjustment apply to at least small part (15% to 20%) of the per unit price of power under the PPA to reflect operations and maintenance expenses. Such expenses are not fixed for the life of the project and can be expected to increase with time due to inflation, unlike capital and financing costs which are typically fixed for the life of the project.
- Minimum Delivery Obligations: If generation is below a stipulated annual minimum, the developer could be accountable to the buyer for losses it suffers in procuring alternative sources of supply. This is doubly painful to the developer as it is both not earning revenue and at the same time responsible for make-up payments to the buyer.
- Maximum Delivery Obligations: If an annual maximum amount of generation is stipulated, typically there is a lower per unit sale price for power generated in excess of such maximum. Occasionally, a PPA will have no obligation on the buyer to purchase such surplus (which would, therefore, have to be sold into the spot market). Ultimately, though, this is more of a equity issue then a lender issue as we are dealing with revenues in excess of projected revenues.
- Construction Related Issues: From a buyer’s perspective there are consequences to the late delivery/construction of a wind farm because the buyer wants the power and green credits associated with such project available on a timely basis. Commonly, a buyer will impose a regime for liquidated damages if a wind farm is not built in accordance with a pre-agreed timetable. The PPA itself could be at risk if an absolute deadline is missed. Force measure provisions, which excuse a party’s performance for reasons beyond its reasonable control, must be prepared with care to mitigate this risk.
- Credit issues: Credit concerns of a party to its counterparty apply to all project agreements, not just the PPA. Credit enhancement may be required if the credit rating of the counterparty is an issue. This could be provided by way of guarantees, letters of credit or cash collateral. These are frequently required by buyers of power (even though most of the credit exposure lies with the developer). A major concern of the developer (and, more particularly, its lenders) that often arises lies with the right of the buyer to assign the PPA to a party that may not have the same credit strength as the buyer (ultimately, such credit strength is based on the buyer’s statutory or regulatory right to pass the costs of power under the PPA on to ratepayers in the applicable jurisdiction). Making such a right of assignment conditional on demonstrated credit strength of the assignee is critical to the lenders.
- Buyers Right to Curtail: A buyer’s obligation should be to take and pay for all power generated. The right to curtail should be limited to force majeure type events, system emergencies, etc. A right to curtail "at will" is a matter that will concern lenders.
- Green Credits, WPPI etc: Ownership of ancillary products and revenues related to the generation of power, such as green credits, capacity payments and WPPI payments etc, can be allocated in the PPA between the parties. It does not automatically follow that these belong to the developer, particularly where the buyer is a utility that requires green credits to comply with a renewable portfolio standard. Such allocation will be reflected in the cash flow projections for the project and will not concern lenders if the requisite debt coverage ratios are otherwise provided for.
Construction Contracts/Turbine Supply
At one time, a "full wrap" contract for the construction of a wind farm was common in Canada. Typically, such an agreement would provide that the turbine supplier would deliverer and erect the wind turbines and construct all aspects of the balance of plant, including foundations, roads, power collection system, substation and transmission interconnection. For various reasons, such a comprehensive and relatively simple approach to construction of a wind farm is no longer available in the marketplace. Rather, we commonly find at least two separate agreements: one for turbine supply with the turbine supplier in question and a second for the construction of the balance of plant with a separate contractor. Occasionally, we see a proliferation of contracts relating to the construction of the balance of plant itself. The risk with multiple agreements is that disagreements and disputes may arise between the various contractors, particularly as to responsibility for problems. This could give rise to delays and higher costs and may be of concern to lenders and equity investors. This problem is mitigated by carefully allocating responsibilities to ensure that the performance of contractual obligations is "seamless".
One common friction point relates to responsibility for transportation and erection of wind turbines. Either or both of these obligations can fall either with the turbine supplier or the balance of plant contractor. Contractual provisions requiring careful coordination and close cooperation between contractors, particularly as to timetable, scheduling, and scope of work, are essential to ensure that the wind farm is built on time and on budget.
Typically contracts relating to construction of the wind farm will provide for liquidated damages for late delivery. Ideally these should compensate developer for lost revenue. At a minimum, they should be structured to strongly deter delay by the contractor in question. Force majuere provisions will provide relief to the contractor in question if delay is due to reasons beyond its reasonable control, but must be prepared with care as such contractor will be relieved of its obligation to pay liquidated damages if it can invoke force majeure.
Some force majuere risks can be defined objectively and allocated in these agreements. One such example is the risk of high winds. High winds do not necessarily affect ground work, but will have a critical impact on the erection of turbines. Given that a windy site is ideal for a wind farm, it is to be expected that the contractor responsible for erection will suffer high wind days that preclude crane lifts for reasons of safety of workers and turbine components. This risk can be allocated in such a manner as to avoid disputes by having an exact definition of which wind speeds (in meters per second) are agreed to be force majeure for purposes of turbine erection and providing the contractor in question with an allowance for high wind days where such wind speeds are in evidence. Only if the allowance is exceeded would the contractor in question be permitted to claim force majeure and shift the risk, and associated expense and delay, to the developer.
Typically the turbine supply agreement will carry warranties relating to power curve and availability in addition to more typical defect warranties. The power curve warranty relates to an assurance by the turbine supplier that the turbines in question will perform at a stipulated threshold of performance in terms of the efficiency of the wind turbines in converting wind energy into electricity. The availability warranty is, similarly, a guarantee of a threshold level of expecting reliability performance of the wind turbines in question. As lenders will take a keen interest in such provisions, they must be prepared with care. One matter of concern here is the reluctance of some turbine suppliers to provide availability warranties with respect to small wind farms.
In a paper such as this I can only touch on a few matters of note. Nonetheless, I hope I have given the reader some indication of the type of issues bound to arise in connection with the financing of wind projects in Canada.