Nov 29,2012 / News / Legal Brief

The South African Department of Energy (DoE)’s Independent Power Producer (IPP) Bid Process is currently underway and preferred bidders are in the process of fi nalising the documentation needed to reach fi nancial closure (the process of ensuring that local and international funders are ready to invest private capital into the power generating projects that they are fi nancing).

This process has generated a staggering number of complicated legal contracts and documents, including the request for proposal documents, bid responses, power purchase agreements (PPAs), construction and operating contracts, site purchase / lease agreements, equipment supply and transport contracts, interconnection agreements, and joint venture and other contracts which, among others, document shareholder and sponsor participation in the projects. Once a full suite of fi nancing and security documents have been added, one would be forgiven for feeling somewhat overwhelmed.

However, of all these documents, it is arguably the PPAs that are the most important, because these deal with the revenue component of each power generating project. Projected revenues, in turn, comprise the single most important criterion that will render a power generation project bankable and ultimately capable of being on-sold to other investors. PPAs need to be carefully crafted and strive to balance the interest of the various parties failing which they can be a major source of risk for the various stakeholders. In this context, we highlight the more critical and unique provisions of a negotiated PPA. It is important to note that the issues raised herein are relevant even in instances where the PPA is not subject to negotiation by the IPP with the buyer as is the case with the current South African IPP Programme.

Each of these provisions shows how the parties to the PPAs in different African countries have sought to navigate the socio-economic and political realities of power generation and supply, and to provide contractual solutions that protect their diverse interests.

This analysis is based on project documentation prepared for energy projects in a number of different African countries, including for example for the “Safi Energy Hub Project” in Morocco, phase 1 of which contemplates the construction and operation of two 660MW Coal-Fired Power Plants along the Moroccan coast line, and which to date we believe remains the largest recent African IPP project to rely successfully on the tender process.

MAJOR STAKEHOLDERS

There are commonly only two parties to a PPA, being the IPP and the entity to whom the IPP will sell the power it produces. In an African context, the latter are often stateowned enterprises such as l’Office National de l’Electricite in Morocco and Eskom SOC Limited in South Africa.

The government in which the IPP proposes to conduct its business, usually acting through the ministry/department responsible for local energy regulation (such as the Energy and Water Utilities Regulator of Tanzania and the DoE of South Africa), will usually have a material say in the content of the PPA, especially in circumstances where it guarantees offtake (see the discussion below on Political Risk). Other stakeholders may include those who sponsor the IPPs’ technological and private equity requirements, banks and other financial institutions funding the project, the EPC and O&M contractors responsible for construction and maintenance of the power plant, equipment, fuel and other suppliers to the plant, insurers, landlords and technical, financial and legal advisors. The project will only be successful if there is cooperation and agreement between all stakeholders.

TARIFF DETERMINATION AND INDEXATION

Given that the PPA is the foundation of a power project’s bankability, the most important provision of a PPA is usually the tariff that the IPP can charge for the power it produces.

Of fundamental importance in a tariff-based PPA is the manner in which the tariff is calculated over the life of the project (see the discussion below regarding the Term). If the tariff does not enable the IPP to recuperate the costs that it incurs in producing power, it is only a matter of time before bankruptcy intervenes. The tariff should therefore be based on a realistic and comprehensive calculation of the Levelised Energy Cost (LEC) (or the price at which power must be generated). As a rule of thumb, it is always a good idea to check what end-users are paying for power generally before agreeing to a tariff or proposing a tariff in a competitive bidding environment.

The calculation of the tariff usually has two distinct components: the fixed costs associated with the start-up of the project and debt service, and those costs that will fluctuate over the life of the project and which need to be indexed. In the first category, it is important to bear in mind the costs associated with the use of specific technologies. For example, it is often more expensive to insure projects employing First of a Kind (FOAK) technologies. In the second category, the PPA must deal with indexation of the major variable cost components of the project. These may include the price of labour (including highly skilled technicians and engineers), construction costs, interest rates, operating and maintenance cost increases, fluctuations in the fuel price (if transportation costs are a material component of the project) and decommissioning costs. This means in turn that drafters and negotiators of the PPA must be comfortable that the information and reports that the parties will use to calculate the tariff are reasonably reliable. As the recent crisis involving the determination of the London Interbank Lending Rate (LIBOR) has shown, an unreliable indexation method could have all kinds of unanticipated consequences.

Of material importance in most PPAs is the manner in which these costs and the costs associated with any changes in law and taxes are passed on to end-users. Particular attention should be paid to whether the PPA is structure on a “take or pay” basis, or on an “as available”, energy-only basis. In a take-orpay contract, the project agrees to sell to the power purchaser its output up to a certain annual amount or for all that is produced.

In return, the purchaser agrees to pay the agreed-to amount for the product, without regard to whether it actually takes delivery. These different structures will have a material impact on projected revenues and therefore on bankability. Equally important is the extent to which the IPP may be incentivized to offer a lower tariff. Many jurisdictions, for example, use a Feed-In Tariff (FIT) to render technologies such as wind and solar competitive with more traditional sources of energy such as coal. From the available data, as of 2010, feed-in tariff policies have been enacted in over 50 countries, including Algeria, Kenya and Tanzania.

Of course there are other provisions in a PPA that are material to the revenue stream. These include testing, metering, processes for settlement and invoicing, and accurate and reliable financial models.

TERM

Once the revenue stream has been established, the remaining primary objective of all stakeholders is to ensure that the PPA remains in force during the entire term of the project and that the risk of force majeure and other adverse events is appropriately allocated and mitigated (see for example the discussion below regarding Political Risk).

In sub-Saharan Africa, PPA lengths have ranged from 5-6 years to 30 years from the Commercial Operation Date (being the date on which the power generating plant in question has been commissioned and tested and is ready to commence power production). There is a clear concentration in a range of 15 to 25 years. Duration should be carefully considered. On the one hand, the IPP should be given sufficient time within which to recoup its investment. On the other hand, the longer the duration, the more expensive the contract may be for the power purchaser and government.

For the negotiators and drafters of the PPA, the length of the term introduces a number of complexities. The most important of these include the legal and economic changes that may occur during the life of the project and that may impact on the pricing provisions of the PPA.

Regarding changes in law, for example, in several jurisdictions, most prominently in the member states of the European Union, renewable energy projects are awarded tradable emissions reductions credits. To our knowledge, such markets are not yet well developed on the African continent, but what is important in an African PPA is that the benefits and risks that are associated with changes in law are adequately dealt with, in anticipation of these markets also developing here. For example, the establishment of a carbon tax might significantly increase the price of power and make emissions credits from energy projects significantly more valuable.

Regarding economic changes, PPAs tend not to have sufficient flexibility in the face of unexpected economic changes. For example, exchange rate movements can put considerable pressure on treasury, particularly where a project is committed to purchase prices denominated in US dollars, while having to on-sell power in the local currency. The absence of appropriate financial hedging instruments for such long-term contracts usually adds to the problem, leaving government with a heavy and uncertain financial burden, ultimately passed on to the consumer.

Another example would be the advent of the European Electricity Exchange, which demonstrates the trend internationally for markets to move away from a highly regulated, tariff-based industry towards a free-market system in which electricity is bought and sold on an energy exchange, much as shares in listed companies are today traded on the African stock and bond exchanges. Most IPPs would not survive a change of this magnitude and accordingly it is important for the PPA to include termination provisions that will enable all of the stakeholders to exit from the PPA in a fair manner, for example through the mechanism of a government buy-out.

POLITICAL RISK

When it comes to investing on the African continent, despite attractive rates of return, investors are still apparently preoccupied with issues of political risk, which would include events such as expropriation, currency inconvertibility, changes to the tariff and changes in the regulatory and tax regimes. It is the duty of those negotiating and drafting the PPA to ensure that these risks are appropriately allocated and mitigated.

How risk is allocated is usually a function of the respective parties’ bargaining power, but also of larger socio-economic and political factors within a given jurisdiction, such as a lack of clear energy policy and a lack of confidence in the judicial process and the ability of local courts, mediators and arbitrators to give effect to negotiated agreements. For example, in a competitive bidding environment, the more concerns the government has about its country’s ability to attract Foreign Direct Investment (FDI) and the greater the demand for power, the more likely that government will be to take on risk. However, after successive rounds of successful bidding and the closer the government gets to reaching its power supply targets, the more likely it will be to push risk down to the IPP.

This element of governmental involvement in power projects sometimes leads to the conclusion of a contract directly between the government and the IPP, in addition to the PPA. In the African context, these agreements are usually referred to as the Implementation Agreements (IAs). It is interesting to note that this appears to be an exclusively African phenomenon – we are not aware of Implementation Agreements being used in any other countries.

Where the bargaining position of the power purchaser/government is strong relative to that of the IPP, one may find issues of political risk tucked away somewhere in the PPA, most commonly in the Force Majeure clause. When a PPA is structured in this way, it is important not to read this clause in isolation, but again to evaluate its impact on the pricing provisions of the PPA. For example, the costs associated with political risk insurance are often extensive and should be included in the calculation of LEC. It is also important to ascertain the extent to which the power purchaser remains liable to pay for contracted capacity, as opposed to actual power generated, in circumstances where the IPP is affected by a Force Majeure event or any similar provisions in terms of which the offtaker remains liable to compensate the IPP for lost revenues as a result of a Force Majeure event.

Where the bargaining position of the parties is reversed, the issue of political risk will be dealt with head-on, usually in the form of government guarantees / indemnities against the losses that the IPP and its sponsors and funders may suffer as a result of politically motivated interventions such as expropriation of project site. When read in conjunction with credit ratings by agencies such as Standard & Poor, and surveys such as the “Ease of Doing Business” rankings published by the World Bank, these guarantees may often make or break a deal for international investors.

Currently, in terms of the World Bank’s ranking according to the “Protecting Investors” criterion for instance, South Africa is ranked highest of the African countries at number 10, followed by Rwanda and Sierra Leone at 29, Botswana, Burundi, Ghana and Mozambique at 46, Angola, Madagascar and Nigeria at 65, Algeria, Egypt, Malawi, Namibia and Zambia at 79, and Morocco, Tanzania and Kenya at 97 (how closely these figures tally with peoples’ experience of doing business in the different African countries is a different story).

STEP-IN RIGHTS

The security arrangements required by power purchasers, banks and other financial institutions are often extensive in the context of energy projects and commonly consist of a combination of parent company guarantees, cash escrows, bonds over the IPP’s land, plant and equipment, reserve funds, letters of credit and control over the IPP’s bank accounts exercised by the funders or their agent.

Unique to project financing are the operational step-in rights commonly afforded to funders, or their agent in the case of a syndication. In principle, these rights afford the lenders or their agent the right to step in to major project contracts, including most importantly the PPA, effectively taking the place of the IPP and thereby taking over the business of the IPP. In practice, it remains unusual in our experience for banks and other financial institutions to actually take over the running of a business in this way. The threat that they may do so is what makes these provisions effective.

DISPUTE RESOLUTION

Dispute Resolution clauses in a PPA are also very important and this is usually a choice between arbitration and litigation. A good PPA will usually contain several layers of dispute resolution and define a clear process as to when and how parties can invoke the various layer of dispute resolution. A dispute resolution alternative that has become popular in the past decade in the resolution of commercial disputes is the use of the World’s Bank International Centre for settlement of investment disputes.

CONCLUSION

As at the date of this article, the available data suggest that much of Africa is still, from a modern energy perspective, an organic economy: 97% of its Total Primary Energy Supply (TPES) comes from biofuels, such as water and firewood, and renewal waste. Electricity generation using renewable energy technology is still largely a pipe dream. “High tech” renewables (solar, wind and geothermal) represent only 0.4% of total TPES. Solar is largely concentrated in Egypt, Morocco and Tunisia, whereas geothermal technology is only available in Kenya and Ethiopia.

When it comes to implementing power projects, experienced practitioners estimate that only 1 in 10 projects ever make it to Financial Close.

In this context, we hope that some of the ideas highlighted in this article about the clauses to look out for in PPAs will help stakeholders to navigate what is undoubtedly a challenging process and we wish the DoE, Eskom and all IPPs and sponsors involved in the DoE’s IPP Bid Process lots of success.

BACKGROUND TO THIS LEGAL BRIEF

Werksmans directors Lize Louw and Nozipho Bhengu recently attended a Master Class in “African PPA Management” presented by Dr Manfred Raschke, President at International Strategic Information Services (ISIS) from Boston in the United States.

Dr Raschke is a world-renowned expert with 29 years of experience as consultant in the international and domestic coal, natural gas and electric power industries. This Legal Brief is based on some of the issues discussed during the course of this Master Class.