The Law of Solar: A Guide to Business and Legal Issues

The Law of Solar: A Guide to Business and Legal Issues

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Jason Johns
Morten A. Lund
Jennifer H. Martin
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Power Purchase Agreements: Distributed Generation Projects

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I. Introduction. The term “distributed generation” is applied to a wide range of facilities using different technologies and varying in size. Due to the sheer variety of solar energy facilities, it can sometimes be difficult to define what is “distributed” and what is not. Perhaps the most common element of distributed generation projects is that they are located on-site. They will typically connect “behind the meter” to the site owner’s building systems, aka the “site host.” Connection to the grid “at the meter” is still important for the site host, though, because of the need to access electricity supply when the distributed generation facility is not generating or is not capable of meeting the full needs of the site host. Complicating the issue further is the recent expansion of virtual net metering and community solar programs, both of which share some features with on-site projects and utility-scale projects. For our purposes here, we will focus principally on on-site facilities.

For distributed generation solar photovoltaic (“PV”) installations, the on-site nature of the project is typically a far larger complicating factor than the intermittent nature of its output. Unlike larger utility-scale projects, distributed generation solar PV may be located in either urban or rural areas, on rooftops or on the ground, on larger structures or on smaller structures, with clear solar access or in congested areas. In addition, the site host may or may not be the power purchaser. Consequently, there is a significant potential for strongly conflicting interests between the passive host with a limited interest in the project and the power purchaser that wants the project output, in regard to what each is willing to accept as reasonable risk allocations with the project developer.

Every distributed generation solar project requires at least two fundamental commitments from the site host and/or the offtaker. Every project needs site rights sufficient to allow the developer to build, operate, and maintain the solar installation on the site and an agreement for the purchase and sale of the power generated from the solar installation. If the power purchaser and the site host are the same, it makes little difference whether the relevant provisions are put in the site lease or the power purchase agreement (“PPA”). However, the site host can lease or sell the premises, thereby changing the identity of the host and party to the site rights agreement. Accordingly, there is no single solution for all situations. In addition, there may be situations where a license, or right to use the project site, may be preferable to an actual lease of the site. The potential for this issue is particularly present when the site host is a municipality or other type of governmental entity.

To distinguish the particular nature of distributed generation facilities and from larger utility-scale projects, we have split our discussion of PPAs into two parts. The first part discusses distributed generation solar PV PPAs and is presented in this chapter. The second part discusses solar PPAs in the context of larger utility-scale projects. To the extent that there are issues in common, the first part will refer the reader to those sections of Chapter 3, Power Purchase Agreements: Utility-Scale Projects for discussion of those issues.

A. The Parties.

1. The Project Owner/Seller. The ownership of a distributed generation solar PV installation is a tax-advantaged investment. As a result, protecting and enhancing the available tax benefits is as important as maximizing revenues. Both are essential to a successful project, and equal consideration should be given to tax benefits and revenue protection. This may change in the not-too-distant future. The federal investment tax credit for solar is set to start phasing out in 2021, and after that the priorities may change. But for now the solar PV market largely relies on the federal investment tax credit, and our discussion below is therefore premised on the application of federal investment tax credit provisions.

To facilitate the pass-through of tax benefits and available subsidies, the project owner/seller in a distributed generation solar PV project will almost always be a limited liability company. The entity will expect to be able to pass through to its members the tax benefits, revenues from power sales, and revenues from the sale of Renewable Energy Credits (“RECs”) that represent the environmental benefits and attributes of the non-carbon-based electricity generation. Depending on the particular forms of subsidy (such as state tax credits, state cash subsidy payments, or solar carve-outs in state renewable portfolio standards designating the amount of generation local utilities must derive from renewable sources by certain benchmarks), the project owner may have more or less interest in actually owning the facility after the tax credit recapture and direct subsidy period has ended (though there are other tax considerations relating to the “profit motive” test that may require the project owner/seller to maintain longer-term ownership of the installation). In other words, the project owner/seller typically has little interest in actually operating or structuring itself as a utility. Solar PV lends itself well to this lack of interest in being a “real” power generator since solar PV is generally considered to have an extremely low level of required maintenance and an extremely high level of reliability. Consequently, the project owner/seller wants to minimize risks to its expected stream of tax benefits, power sales revenues, and REC sales, particularly those that the project owner/seller considers to be within the control of the site host or power purchaser to prevent or avoid.

The project owner/seller’s ability to pass through the tax benefits to third parties is fundamental to a tax equity investor being willing to provide financing to a transaction. The tax equity investor typically has an even larger desire to exit the transaction after the tax and subsidy benefits have been exhausted than a developer/owner. For this reason, many distributed generation solar PV transactions have been structured using a “flip structure” where the tax equity investor starts with typically 99 percent of the ownership interests in the pass-through project-owning entity, which “flips” to a 5 percent interest after the tax equity investor has received the return on investment that has been negotiated between the parties.

Additionally, and regardless of the specific structure utilized, the party that expects to receive the federal investment tax credit must be the “owner” of the installation on the date the installation is “placed in service” for federal income tax purposes. Consequently, all structures for distributed generation solar PV projects are premised upon the need to have the tax equity investor in ownership prior to the placed in service date. Many potential investors want to avoid any construction period risk by delaying their contributions until after the installation is completed and has proven to be functioning in accordance with its intended design specifications. Project developers should be aware of the problems that can arise if the investors are not willing to put any funds at risk prior to completion of the project.

2. The Buyer. The power purchaser typically is interested in reducing its energy costs at a specific location. This can be a single manufacturing facility, an office building, an automobile dealership, a warehouse, a school, a hospital, or a public facilities maintenance building. As the market is realizing, there is an enormous opportunity to place safe and passive solar PV installations in a wide range of locations. The main physical constraining factor is available useful space. In addition, various state regulatory hurdles often make it difficult to install the full capacity a site host could physically accommodate. See Chapter 5, Regulatory and Transmission-Related Issues. For these and other reasons, the power purchaser from a distributed generation solar PV facility will usually be a party with a long-term commitment for a large facility, who is looking for a long-term plan to fix and reduce energy costs. In essence, this power purchaser just wants to receive the power with the minimum amount of additional risk and financial obligation. In previous years, solar PV buyers were principally motivated by a desire to “go green,” but with the sharply reduced cost of solar energy, today the motivation is usually financial.

3. The Site Host. If the site host and the power purchaser are not the same (or closely affiliated), the site host may become a silent partner (or at least an ever-present consideration) in the negotiation of the PPA. Although not as true for a ground-mount installation, a rooftop installation is generally in place for a long time on a structure that was probably not specifically designed to accommodate a solar PV installation. This can raise a number of issues regarding (1) the timing and need for routine rooftop repair, maintenance, and replacement (including both the costs of having to move the installation to allow repair or replacement and the lost revenues from power sales while the repair or replacement is going on); (2) the possible need for structural improvements to support the solar PV array; (3) the susceptibility of the solar PV array to high wind conditions and other climate factors where it is located; and (4) the problems of changing ownership or occupancy of the structure during the term of the PPA. The project owner must recognize that these situations pose objective risks that may disrupt the production of electricity from the installation temporarily or permanently.

These risks need to be allocated among the parties in the best position to protect against their occurrence, but always in a fashion that provides sufficient protection for the project to remain financeable. This can be particularly challenging when the site host is not also the power purchaser. Such a site host will tend to not want to bear any of these costs that may be outside its normal costs and risks of doing business, such as providing for roof repair, maintenance, and replacement. At the same time, a power purchaser that does not own the building or structure it is occupying is likely to view these as risks that it is not normally asked to assume as a “mere tenant.” The fact remains that the project owner is making a significant financial investment that will depend on all of the various economic returns from the project, tax benefits, power sales revenues, and REC sales or other subsidies to make a reasonable return on its investment. No solar PV project is so economically “rich” that allocating these risks can be overlooked. To make sense of how the power sales aspect of a PPA interacts with these “other” concerns, it is first necessary to discuss how a typical PPA deals with the actual sale of output from the solar PV installation.

B. The Power Sales Aspect of the PPA.

1. Standard Terms. Most current distributed generation solar PV PPAs simply provide that the buyer will buy all of the electricity generated by the installation at the price specified in the PPA and the electricity will be delivered at the point of interconnection with the buyer’s (or site host’s) electric system (“behind the meter” delivery). In other words, the obligation to pay is based on the actual receipt of output at the specified point of delivery, and payment is determined by reference to the amount of output delivered. By contrast, a “take or pay” contract specifies a certain amount of money the purchaser is obligated to pay each year (expressed as a minimum volume of energy at an agreed unit price) regardless of whether the installation actually produces output. Given the host/offtakers’ expectations of substituting solar energy for utility-provided energy, and the developers’ interest in guaranteeing system performance, “take or pay” contracts have not found a place in the distributed generation marketplace.

2. Pricing the PPA. The electricity to be delivered under a solar PV PPA is typically priced at a set cents-per-kWh, usually with an annual escalator. The initial price is sometimes calculated so as to provide a specified discount to the current utility retail rate, but there is now significant downward pressure on PPA prices for distributed projects as module prices have dropped. Competition among providers is now the principal driver for PPA pricing. Occasionally a PPA is priced on a variable basis as a discount from utility retail rates during the PPA term. These utility-discount variable-rate PPAs are generally disfavored by financing providers, and are much less common than in previous years.

It is unlikely these considerations will change significantly going forward. Even if regulatory actions, such as passage of a cap and trade bill by Congress, cause changes in the market rate of electricity, electricity from distributed generation solar PV installations will probably continue to be priced in reference to utility retail rates.

3. Performance guarantees are fairly unusual for distributed generation projects, but they do occur from time to time. In the case of an output guarantee there will typically be a provision stating that power output will decrease annually by a fixed percentage, usually about 0.5% per year. Regardless of calculation methodology, the project owner/developer should attempt to make certain that the threshold is set low enough that it is never triggered.

4. Net Metering Expectations. Many power purchasers enter into solar PV PPAs with the expectation that any unused output can be sold to the local utility. Net metering is one way in which the power purchaser expects that it can gain a financial benefit from any excess electricity delivered by the solar PV installation in excess of the power purchaser’s immediate need. Another is the potential to sell power to the local utility. In the limited circumstances the latter option is available, the price is typically at or below wholesale levels.

The PPA itself will usually not have any provisions dealing with these situations because the typical solar PV installation is delivering behind the meter for the immediate use of the power purchaser without the requirement of any use of the local utility’s grid for transmission. The project owner/developer should consider including language in the PPA specifically disclaiming any responsibility for the ability of the power purchaser to net meter or sell excess energy.

Net metering and the limited circumstances in which a power purchaser may be able to sell its excess output to the serving utility are discussed further in Chapter 5, Regulatory and Transmission-Related Issues.

II. Standard Provisions of a PPA.

A. Term of the PPA. The current standard appears to be that the PPA will have a length (“term”) of 20 years, though 15 years is also common. To some extent, the term is dictated by the project owner’s desire to receive, or need to receive, a certain rate of return from its investment. It is increasingly common to see PPAs with terms significantly shorter than 15 or 20 years, although shorter PPAs can be more difficult to finance. It is standard in solar PV PPAs that the project owner is responsible for paying the costs of removing the installation from the site upon the natural termination of the PPA. However, if termination occurs early due to an event of default caused by the power purchaser or a termination declared by the site host, this cost typically shifts to the purchaser.

B. Installation, Testing, and Start-Up. Most PPAs contain an obligation on the part of the project owner to cause the project to be installed, set out the conditions relating to pre-operation testing, and define when the project will be considered “placed in service” (important for tax considerations and not requiring full actual operation) or in “commercial operation” (which relates to commencement of project eligibility for power sales and usually requires that the project produce and deliver electricity at the standards set forth in the PPA). The project owner will usually satisfy its obligation to construct and install the project by entering into an installation agreement with an experienced solar installer. The installer will then undertake the obligations of testing the project, obtaining certification that the project has reached commercial operation, and completing the final punch-list items necessary to perform the installation contract. Pre-operation testing for a solar PV installation is usually quite simple: hook the system up for a set period of time (usually four hours for small projects, and longer for larger projects) and meter the output to see if it is producing within design parameters. If it does, it has passed its required pre commercial operation testing and will be considered placed in service. For more on installation agreements, see Chapter 4, Solar Energy System Design, Engineering, Construction, and Installation Agreements.

C. Project Operation and Maintenance (“O&M”). The solar PV PPA typically will provide that it is the project owner’s responsibility to maintain the installation. Several standards are usually specified, such as conformance to prudent utility practice, prudent solar industry practice, or best practices, but they all mean essentially the same thing: the installation must be maintained so that it does not pose a danger to individuals, to the structure on which it is located, or to the grid, and so that it will produce electricity in accordance with contractual expectations. The project owner will often fulfill this obligation via a third-party O&M contract. Many installation contractors also desire to handle O&M, and may extend the term of their equipment and installation warranty (two or three years, increasing to five or 10 years) if they are awarded the O&M contract.

D. Project Purchase Options. An option for the power purchaser or site host to purchase the solar PV installation at some defined point during the term of the PPA is a common feature of solar PV PPAs. As with the pricing structure, the times at which this purchase option may be exercised vary widely.

1. Purchase Option Points During the PPA Term. It is common to have a purchase option exercisable after some or all of the sixth, tenth, or fifteenth year, or on the natural expiration of the PPA. Occasionally the purchase option is exercisable at any time after the sixth year, or any time at all. Granting a continuous purchase option presents significant issues for the project owner/seller including potential recapture issues.

2. Pricing the Purchase Option. A project owner considering granting a purchase option is faced with a combination of tax considerations and economic business considerations. The principal consideration is the requirement that the purchase price be no less than fair market value. If the purchase price is below fair market value, there is a risk that the IRS will reallocate the investment tax credit to the power purchaser instead of the project owner. There are two common methods of setting the purchase price. The most common method is to have an appraisal at the time of the option exercise, and the purchase price is set as the fair market value as determined by the appraiser. Recently, it has become increasingly common to agree to a set price in advance. This set price is determined using appraisal and accounting tools to be at least fair market value at the time of the option exercise. An additional limitation is the five-year recapture period for the federal investment tax credit, during which any exercise of a purchase option will trigger recapture of a percentage of the federal investment tax credit received by the project owner. An exercise of a purchase option during this period is therefore typically not allowed. If a purchase option is allowed during this time, the purchase price will be increased to compensate for lost or recaptured tax benefits.

E. Off-Ramps Before Construction, Events of Default, and Other Common Provisions. See Chapter 3, Power Purchase Agreements: Utility-Scale Projects for a discussion of standard event of default provisions that are generally applicable to both distributed generation solar PV PPAs and utility-scale PPAs, other than those dealing with the creditworthiness of offtakers, guaranties, and other financial accommodations, which typically are not found in distributed generation solar PV project documentation.

III. On-Site Issues in a Distributed Generation Solar PV PPA. Several issues arise from the on-site location of distributed generation installations that are relatively unique to these types of electric generation projects. They will be encountered in any distributed generation facility regardless of technology, but the large increase in the installation of distributed generation solar PV facilities makes them an excellent template for discussing these issues.

A. Structural Integrity. Installing a solar PV system on the rooftop of an existing structure will put a significant weight load onto a structure that may not be rated for that weight. Placing a solar PV installation on a structure that cannot easily bear the weight is a clear danger to health and safety, and poses a potential threat of damage to the structure itself. A careful survey of the weight-bearing load capacity of any building on which a solar PV installation will be placed should be done before going very far into the negotiation process. Structural reinforcement may be required, and the costs of those improvements may prevent the installation from being economically viable. The only option other than making structural improvements may be downsizing the proposed installation to reduce weight. The site host, power purchaser, and project owner each have a direct and clear interest in being certain the structure on which the installation will be placed can bear the load for at least the full term of the PPA. Nonetheless, the responsibility (and risk) of structural integrity must be allocated to a party, and this can be a hotly negotiated topic.

B. Repairs and Replacement. Many roofs will require maintenance and repairs at some point or points during the term of the PPA. In addition, most roof coatings are designed with a known useful life. Exceeding the useful life of the existing roof may require the solar installation to be moved or removed from the rooftop to allow repair or replacement of the existing roof. There is a direct economic cost from both disconnecting the installation and moving it out of the way on the rooftop and disconnecting it and moving it off the rooftop while repair or replacement is conducted. That cost is the loss of power sales during the period the installation is out of service, as well as the loss of any REC sales or other subsidies that depend on the installation being in production. Project owners will often grant the power purchaser or site host some agreed period of time in which there will be no penalties incurred to accommodate ordinary repairs and maintenance. If the installation downtime will exceed this agreed-on period, many PPAs will require that the power purchaser start reimbursing the project owner for lost power sales, lost REC sales, and other lost economic benefits. If the power purchaser is not the site host, this presents a clear need to coordinate the PPA and the site lease, license, or easement to handle this risk.

C. Sale of the Structure or a Change of Tenant. Distributed generation installations also present the unique problem that ownership of the structure on which the installation is located may change during the term of the PPA, or the tenant that was previously the power purchaser may move out and a new tenant that is not interested in assuming the PPA may move in. There is no single, clear, simple solution to this problem. The site lease, license, or easement will usually require that any purchaser of the structure assume the site lease, license, or easement (i.e., it is an encumbrance that “runs with the land”). The site host may want to require a new tenant to assume the PPA as well, but if the new tenant is unwilling and has sufficient leverage with the site host, that may not happen. Consequently, even if the project owner believes it is adequately protected from these situations under the project documents, the project owner is faced with a difficult decision. There is a substantial cost attached to the project owner’s enforcing its legal rights, as well as immediate lost revenues of various types if the new owner or tenant simply will not accept the delivery of electricity from the solar PV installation. This is a central issue to project success, and should be addressed carefully in the agreements.

D. Ground-Mount On-Site Issues. A ground-mount installation presents a different range of issues than a rooftop installation. Gone are the concerns about structural integrity, roof leakage, tenants, and multi-use properties. Instead, ground-mounted systems face a greater range of environmental compliance risk and regulation. These risks and obligations should be carefully allocated between the site host and the project owner. Typically, the site host will be responsible for all nonproject hazardous substances and other environmental risks, while the project owner is responsible for project-related environmental matters.

IV. Distributed Utility PPAs. Certain utilities, including the Southern California Edison Company (“SCE”), Pacific Gas and Electric Company, and San Diego Gas & Electric Company in California, have received authority to enter into PPAs with distributed generation solar installations owned by independent power producers. For example, the standard form of PPA used for the SCE program combines provisions typical to distributed general solar PPAs with some provisions typically used only in utility-scale solar PPAs, although in a more limited form than usual for a utility-scale PPA. For example, a security deposit calculated at a fixed dollar amount per kilowatt that will be held by the utility is required. If the developer fails to install any of the equipment or devices required to provide output at the designated gross power rating for the installation under the PPA by the defined starting date for power sales, the entire deposit is forfeited to the utility. If only a portion of the designated gross power rating of electricity is delivered by the defined starting date for power sales, a portion of the security deposit is forfeited. This type of security deposit is common in utility-scale PPAs but is relatively uncommon in distributed generation PPAs. Due to the character of the power purchaser as a regulated public utility, regulatory approval of the PPA is required, and the power seller is required to operate the installation in compliance with certain regulatory tariffs. Such provisions are common to utility-scale PPAs but uncommon for typical distributed generation PPAs. In addition, these hybrid PPAs are silent on the issues that typically must be dealt with between the developer/project owner and the site host discussed above. The developer/project owner must solve these on its own, and the purchaser utility has no role or interest in those issues.

V. PV System Leases. It can be seen that in the distributed generation context, a PPA is more a financing device than a commercial agreement for the sale of electricity. It allows the host/offtaker to gain the benefits of PV generated power with little or no upfront capital expense. The PPA does this by moving ownership to a third party that has the available capital for investment and is able to take advantage of the tax benefits of PV system ownership. The host/offtaker essentially pays for the system over time. Under the PPA, the payments are based on units of electricity. In an ordinary loan, the payments of principal and interest would offer similar benefit to the host/offtaker and similar payment structure. A third financing device, offering benefits to the parties similar to those afforded by a PPA, is the system lease. As in an automobile lease, the lessee/host/offtaker contributes a relatively small upfront payment, then leases the equipment and pays the system owner rent for an agreed term. As in PPAs, there are typically early termination charges and options to purchase. IRS regulations require there to be at least 20 percent residual market value in the equipment at the conclusion of the lease term. For this reason, lease terms tend to be shorter than PPA terms.

VI. Conclusion. The project owner must carefully consider how to integrate the on-site issues presented by a distributed generation solar PV system with the basic purpose of the PPA, which is to cover the project owner’s agreements with the power purchaser regarding the installation, start-up, maintenance, and sale of output from the system. Any situation in which the PPA will be with a party other than the site host will raise the question of whether these on-site-specific provisions should be in the site lease, the PPA, or a combination of the two, depending on what the project owner is able to negotiate with the site host and the power purchaser.

Simply ignoring these issues is an option for the project owner, but one that needs to be taken knowingly. While a developer/owner may elect to take these risks, most tax investors and banks will not. Failing to adequately address these issues will make third-party financing very difficult.

As to the basic core terms of the PPA, the discussion above indicates that there are many different approaches to each provision being used in the market. At this point, there is no single set of deal points that is generally accepted as the industry standard, although most experienced investors and attorneys will recognize a “bankable” PPA when they see one. Download The Law of Solar - 5th Edition (PDF)

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