Part II of Renewable Energy Projects on Contaminated Property | Managing the Risks
The First entry can be found at Part I
Risk and Exposures in the Life Cycle of a Project
The typical renewable energy project involves multiple parties: tax equity investors; equity investors; local utilities; engineering, procurement, and construction (EPC) contractors; operation and maintenance providers; renewable energy certificate (REC) buyers; host customers; and local, state, and federal governments. However, the project as a whole raises common exposures and perils for all of these parties. Successful risk mitigation depends upon not only identifying potential loss exposures but also understanding the perils causing such loss exposures and the context in which those perils arise during the phases of a project’s lifecycle: project development, construction, operation, and decommissioning.
Initially, owners/developers of a renewable energy project must assess technological feasibility, determine project structure, assess regulatory risks, negotiate key contracts, and make an overall assessment of market conditions. The following risks are presented during this initial project development stage:
• Acquisition of necessary permits and approvals is not successful;
• Connection to the electricity grid is not feasible or too expensive;
• Energy purchase agreement does not meet conditions posed by investors or lenders;
• Regulatory policy changes delay project development or affect project viability;
• Increased costs of equipment and services.
Regulatory changes are of particular concern. Regulatory risks include not only the typical real estate-related risk of being unable to obtain the necessary permits and licenses essential to project implementation in a timely fashion, but also the more significant risk of adverse policy changes that might occur during a project’s lifecycle that may have significant impacts on project profitability. Investors, developers, and lenders need to be mindful of the web of federal policy and regulations controlling renewable energy assets. Much of this falls under the purview of the Federal Energy Regulatory Commission (FERC), which is granted authority under the Federal Power Act (FPA). FERC’s regulation of electric utilities and transmission forms a complicated and technical web of approval requirements, notices, and subsequent reporting requirements that must be met by the parties to a transaction. Unless exempted by qualifying for “small power production facility” status under the Public Utility Regulatory Policies Act (PURPA), owners and operators of generating facilities must comply with the provisions of Part II of the FPA and corresponding FERC regulations. Such regulation can potentially add years to the regulatory approval process.
As a project moves into the construction phase, several risks are presented, none of which are unique to the renewable energy sector:
• Cost and/or time overruns may negatively affect the cash flow of the project;
• Contractor or subcontractors may not be able to meet the agreed upon technical specifications;
• Contractor or suppliers may not perform as per the negotiated contract.
The risk profile of the operational phase is crucial in determining the appropriate financial parameters of a project. Any disturbance in the production of energy will necessarily result in lower project income. Several risk types are relevant to this phase:
• Performance risks:
- Underperformance of technology;
- Underperformance of technology due to improper installation;
- Underperformance of operation and maintenance (O&M);
- Security-theft / equipment damage, terrorist attack.
• Resource risks:
- Variable availability of resources (e.g., windspeed profile or solar irradiation, or disturbance in biomass supply);
- Natural catastrophe.
• Market risks:
- Demand risk (uncompetitive pricing policy of renewable energy projects);
- Price risk (changes in market prices).
Finally, the risks presented during the decommissioning phase of a project are generally low. In many cases, the scrap value of the installation is higher than the decommissioning costs. However, disposal value at end of project life can be affected by increased cost of disposal and decreased financial feasibility for project overhaul. Thus, in many cases regulatory requirements
impose the creation of some kind of decommissioning fund, which must be funded during the operation phase or at the beginning of the project.
Risk Transfer Mechanisms
One question pervades the above phases of a project’s lifecycle: does the project structure provide the financial support necessary for successful project implementation? Well-drafted contract provisions in the agreements between the primary parties to a project, e.g., the project entity, facility owner, and utility, that are fully integrated with an insurance program addressing the exposures and perils of those parties will often make projects bankable. Such agreements, i.e., the PPA, the interconnection agreement, lease or purchase and sale agreement (PSA), should provide exit strategies that track the perils that may make a project economically unfeasible. Additionally, a project entity typically enters into a myriad of subsidiary contracts with various parties for the realization and operation of the overall project. These may include contracts with equipment suppliers, resource acquisition/fuel supply agreements, investment agreements, interconnection and net metering agreements, offtake contracts, engineering procurement and construction (EPC)/installation agreements, operation and maintenance (O&M) agreements, marketing agreements, and REC sales agreements. The effectiveness of the terms of those subsidiary contracts in mitigating perils is also essential as those terms often dictate investor and lender terms for renewable energy projects.
The PPA entered into by the public/private sector buyer and the project entity is perhaps the most crucial and highly complex component of any renewable energy project. It is an agreement for the sale and purchase of electricity and sets out the rights and obligations of the buyer and the project entity. It is also designed to address a variety of risks over a long term. Basic terms of a PPA include project term, price, amount of electricity to be produced and purchased, measurement of electricity, point of delivery and transfer of title and line losses, insurance and indemnification, how renewable energy certificates or carbon credits will be treated, and removal of the system. The agreement allocates risks for delays in construction and defines damages for breach of contract. Power purchase agreements may also contain provisions for equipment leasing and financing and site lease in cases where the facility is on buyer’s land. Project entities often find themselves as intermediaries balancing the interests of the host and the finance parties during the negotiation of the PPA.
Price is often the most negotiated term in a PPA. Price should be negotiated based on the cost of infrastructure and installation (including the administrative time to obtain necessary regulatory approvals), the efficiency and output of system, the present rate of electricity from the utility and anticipated future increases, and the actual or anticipated value of RECs.
Another crucial concept of the PPA is the point of delivery, or the point of interconnection between a project and the utility. Typically, all equipment on the project side of the point of delivery is the responsibility of the project entity. Thus, the risk of adverse conditions affecting minimum load delivery, power system interruptions, or overload and loss of system generation is all born by the project entity.
Most PPAs allocate risks and exposures through carefully drafted representation and warranties and indemnity and insurance provisions. The former may contain a covenants clause in which specific perils such as regulatory risks are addressed and that assign rights and responsibility for RECs. The latter typically allocate broad categories of loss exposures (all damages, loss, claims, liabilities, obligations, costs, and expenses, etc.).Most indemnity provisions in a PPA will only provide indemnity for claims arising out of acts or incidents first occurring during the period when control and title to the product is vested with such party (i.e., the period when the product crosses the point of delivery). Additionally, well-drafted indemnities may provide that neither party is liable to the other for consequential, incidental, or indirect damages, lost profits, or other business interruption damages. Often, however, the insurance provisions of the PPA stipulate that the required insurance cover some of these damages, particularly business interruption.
In addition to the central PPA and lease agreements, EPC and O&M agreements also allocate risks and exposures. EPC agreements provide for the design engineering and procurement of equipment and construction of infrastructure projects. There is an advantage to addressing these issues in a single, comprehensive agreement with one contractor that can provide for turnkey project construction transferring the responsibility and risk associated with construction costs and delays to the contractor. The agreement should contain performance guarantees, liquidated damages for nonperformance, and due diligence standards for the selection of subcontractors and suppliers. It is equally important that the contractor provide insurance, including professional liability and CGL insurance, that can support or complement its guarantees and indemnities. For instance, the risks associated with error or omissions in design can be covered in such agreements so as to avoid any design defect exclusions contained in insurance policies. Additionally, for many renewable energy projects, there exist technological risks inherent in generation technologies that continue to evolve. Outsourcing of operation and maintenance (sometimes to the same EPC contractor) and well-drafted equipment warranties can mitigate such risks. O&M agreements must ensure compliance with project contracts (including warranties) and compliance with offtake contracts, or PPAs. These EPC and/or O&M agreements should have appropriate insurance requirement clauses to support or complement such risk allocation provisions.
The insurance sections of a PPA (and often the corresponding interconnection agreement) are often very specific about the types and characteristics of the policies required, particularly the property and commercial general liability (CGL) policies. They often mandate that property policies provide full replacement costs, cover particular perils such as wind, flood, and earthquake, and contain business income and extra expense coverage (which applies to business interruption), boiler and machinery or machinery breakdown coverage, and (if a new building is planned) builder’s risk coverage. The CGL requirements typically include bodily injury and property damage, products and completed operations, and personal injury liability coverage. Additionally, they often require contractual liability coverage under the CGL policy (which makes sense in view of the many parties and contracts involved in a renewable energy project) and sometimes require that the CGL policy have sudden and accidental pollution coverage.
It is important to note that, although a project entity may already have many of the above insurance policies, those policies will not necessarily address risks specific to a renewable energy project or fulfill some of the specific requirements mentioned above. Thus, it is important to involve an insurance broker with a specialty in renewable energy early in the process. The broker should approach the energy department of an insurance company with particular experience in and the capability to underwrite alternative energy clients and projects. Those carriers have demonstrated that they know how to insure and assess risks for renewable energy producers, distributors, sites, and technologies including wind turbines, ethanol and biodiesel plants, solar energy systems, and hydroelectric power generators. Their policies will have special endorsements with language appropriate to these exposures and their perils.
Further, the insurer should be one that also has an environmental department that can issue SPL policies (and the broker who goes to the insurer should specialize in environmental as well as energy issues). It is telling that some PPAs in a renewable energy project require sudden and accidental pollution coverage under a CGL policy. Clearly, there may be a concern, particularly by landowners who are not operating facilities, that the on-going operations of a renewable energy facility may create new pollution conditions. However, true environmental coverage can never be obtained under a CGL policy; most environmental endorsements to CGL policies provide illusory coverage at best.
For instance, they do not usually cover cleanup costs. (And CGL underwriters do not know how to underwrite environmental exposures.) Therefore, environmental concerns should be addressed by an SPL policy that accompanies the property and CGL policies. In contrast to the CGL policy, the commercial property policy issued by such an energy department (or otherwise) potentially
provides significant environmental coverage that may overlap with SPL policy coverage. It is always wise to obtain potentially overlapping coverages from the same carrier to avoid duplication of coverage and therefore higher costs.
Environmental coverage under the property policy would in a broad sense include coverage for the effects of climate change, e.g., the wind, floods, and earthquake coverage such as often mandated in PPAs. Such perils are not only directly covered under the property policy but their coverage is further facilitated by exceptions to its pollution exclusion in the property policy. including those for “specified perils,” which usually include many of the very same climate change-related perils. Pollution exclusions in property policies contain other exceptions, varying from carrier to carrier, and the language of these exceptions should be carefully scrutinized to understand the breadth of the policy’s pollution coverage. Most property policies also cover first-party on-site environmental cleanup costs (although usually with a small sublimit of no more than $50,000). Mold coverage can also usually be added by endorsement.
Green building coverage is also an environmental coverage since freedom from indoor air pollution and energy efficiency are environmental issues, and indoor air pollution can be covered by the SPL as well as the property policy. Although some carriers provide this coverage by endorsement to other sorts of policies, it is best obtained under the commercial property policy used for renewable energy projects and other real estate transactions. Green building coverage pays for restoring a building or other property to its previously green condition after a loss, or for upgrading that property to green after a loss. In the case of a loss to green technologies, the policy may cover the cost of rebuilding that technology system. This coverage can potentially fulfill contractual requirements that insurance include full replacement costs. The loss payment provisions and the “ordinance or law” provision in the property policy should be carefully scrutinized for how well they address the replacement cost and green building coverage issue.
Part III will be published shortly.
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