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WHY POWER PURCHASE AGREEMENTS
Rising energy prices and federal renewable energy goals are driving federal agency demand for renewable
energy sources to control costs and meet new requirements. Over the last decade, electricity prices have risen at
a rate greater than inflation and have been an unpredictable cost in annual agency budgets. The U.S. Energy Information Administration reported a 42% increase in electricity prices for all sectors from 1997 to 2008. In just one year from Fiscal Year 2005 to 2006, federal costs for electricity increased by 8.6%. Furthermore, the Energy Policy Act of 2005 mandated that federal agencies obtain at least 7.5% of their electricity from renewable energy sources by 2013. These pressures combined with budget-cutting are compelling agencies to seek new financial solutions to realize renewable energy projects.
While renewable energy sources have been available for some time, solar power has become increasingly attractive to federal agencies because of declining prices and advances in technology. This is prompting federal agencies to adopt solar power more broadly. The Government wants on-site solar; solar developers want to build more projects; and the investment community is always interested in financing profitable projects. All of this creates jobs and allows for reinvestment in the next stage of the solar industry. A power purchase agreement (PPA) is the financial tool that can bring it all together.
PPAs allow federal agencies to build solar energy projects on-site with no upfront costs. Additionally, a PPA allows an agency to get a fixed electrical rate on a long-term contract. A fixed rate is possible because solar power projects have no fuel costs, unlike gas or coal whose prices fluctuate and can drive up the cost of electricity.
A solar PPA with a term between 20 and 30 years can stabilize a portion of the utility costs for the Government.
1. Independent Statistics & Analysis, Electric Power Monthly: Average Retail Price of Electricity to Ultimate Customer. Table 5.3 Total by End-Use Sector (U.S.
Energy Information Administration, U.S. Department of Energy, May 2011), http://www.eia.doe.gov/cneaf/electricity/epm/epm_sum.html.
2. Federal Energy Management Program, Report to Congress on Federal Government Energy Management and Conservation Programs Fiscal Year 2006 Annual (Assistant Secretary, Energy Efficiency and Renewable Energy, U.S. Department of Energy, November 26, 2008), http://www1.eere.energy.gov/femp/pdfs/annrep06.pdf, P2.
3. Federal Energy Management Program, Overview of Federal Energy Management Policy and Mandates (U.S. Department of Energy, Accessed May 31, 2011), http://www1.eere.energy.gov/femp/pdfs/overview_policy_mandates.pdf, P2.
Nellis Air Force Base and Fort Carson in 2007 overcame the term limitation hurdle. Agency interest in PPAs has been evident from the release of many PPA requests for proposals (RFPs) between 2008 and 2009. However, almost all of these PPAs required a 10-year term according to the Federal Acquisition Regulation (FAR) contract term limit. Consequently, these projects rarely crossed the financing finish line because they could not attract affordable capital. In 2010, the Naval Facilities Engineering Command Southwest (NAVFAC Southwest) received approval for a 20-year term using a Department of Defense (DoD) authority that permits a 30-year term. The multiple award contracts are currently in negotiations and are being closely watched in the Government contracts and solar communities.
The time has come for a Government-sanctioned power purchase agreement that will help federal agencies meet their environmental goals and control costs while driving solar power to a new level of adoption.
SECTION 1 A power purchase agreement (PPA) is a contract PPA Pricing Scenarios between a solar system owner and the host, which There are two primary PPA pricing scenarios: fixed consumes the electricity. A PPA allows a federal escalation or fixed price. The fixed price scenario agency to host a solar power system with no upfront sets one price for the duration of the agreement. The costs. In exchange, the agency agrees to purchase starting electrical rate may be higher than the utility electricity from the system owner at a pre-determined rate, but as energy costs rise, the average rate is rate over a 20 or 30-year term. expected to be lower. Many times, the Government cannot tolerate a starting rate that is higher than the A solar developer designs and builds the system, actual utility rate and will opt for a fixed escalation.
and a tax equity investor finances the project and receives the tax benefits. Large financial institutions The fixed escalation scenario sets a price for the and insurance companies are typically the tax agency, but a predetermined rate of increase is agreed equity investors in these projects. As opposed to the upon in the PPA. According to the National Renewable Government which doesn’t pay taxes, the investors Energy Laboratory (NREL), this price escalation rate have the financial ability to fully absorb tax credits as is typically 2-5%. In some rate structures, the price well as take advantage of accelerated depreciation. will escalate for a certain time period and then be This structure allows large-scale solar projects to be fixed for the remainder of the agreement. This fixed constructed without the need for a capital budget escalator gives an agency budgetary predictability allocation by the Government. The Government and relief from volatile electrical rates. Case in point, simply uses its utility expense budget to pay for the the average retail electrical price for all sectors electricity and is insulated from volatile fuel prices. increased by 7% from 2004 to 2005. The difference between 2005 and 2006 prices was a 9% increase Under a PPA, a special purpose entity (SPE) is formed in rates. Three percent and 9% increases occurred the usually as a limited liability corporation (LLC), which next two years. Clearly, a fixed escalation PPA gives is owned by the tax equity investor. The developer agencies far more predictability for budget forecasts sells the system to the SPE, and the SPE becomes the than what’s happening in the energy market.
system owner who sells the electricity to the agency over the life of the PPA. Oftentimes, the developer continues to play a role in performance guarantees and maintenance of the system. At the end of the PPA term, the Government can extend the contract, buy the system, or have the system removed.
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Other less common PPA pricing models exist. One structure allows agencies to apply project funding to prepay for power that will be generated by the system, essentially buying down the long-term rate. According to the NREL, “this structure takes advantage of a government entity’s ability to issue tax-exempt debt or to tap other sources of funding to buy-down the cost of the project. Prepayments can improve economics for both parties and provide greater price stability over the life of the contract.” Most other PPA models that exist involve higher risk to the developer and subsequently are quite rare.
The different PPA options give the Government a lot of flexibility in finding the right contracting mechanism, and several key benefits to be explored in the next section make the PPA particularly appealing to federal agencies.
4. Brendan Canavan, et al., Power Purchase Agreement Checklist for State and Local Governments (National Renewable Energy Laboratory, May 2008), http://www.nrel.gov/docs/fy10osti/46668.pdf, P3.
5. Canavan et al., P3.
6. Independent Statistics & Analysis, Table 5.3.
7. Canavan et al., P4.
SECTION 2 PPAs give federal agencies a viable financial mechanism to realize solar power projects, thereby allowing agencies to meet EPACT requirements and long-term cost-cutting goals. PPAs remove much of the burden of managing a solar power system from the agency, and they create a situation where the Government only has to pay a utility bill. The simplification of the path to solar power is a big reason why many agencies are turning to PPAs.
Key Benefits of PPAs Perhaps the most important benefit of a PPA for cash-strapped agencies is the arrangement’s no upfront cost. This allows agencies to commission a solar project without having to re-allocate budget, which would often mean cutting other programs. With recent budget cuts, some agencies will find that a deal with no upfront costs is the only way to commission a solar project.
Other top benefits of the PPA include:
Under a PPA, the Government can benefit from tax incentives without actually realizing them. Without the investor, a tax-exempt entity can’t use credits like the 30% investment tax credit (ITC). Consequently, an agency
would often be limited to purchasing a much smaller solar system. The Environmental Protection Agency states:
“SPPA [solar power purchase agreement] arrangements enable the host customer to avoid many of the traditional barriers to adoption for organizations looking to install solar systems: high up-front capital costs; system performance risk; and complex design and permitting processes. In addition, SPPA arrangements can be cash flow positive for the host customer from the day the system is commissioned.”
8. Environmental Protection Agency, Solar Power Purchase Agreements (EPA, June 2, 2011), http://www.epa.gov/greenpower/buygp/solarpower.htm.
A PPA also allows tax equity investors to take advantage of the Modified Accelerated Cost Recovery System (MACRS), which is unavailable to government agencies. “The Internal Review Service allows investors a five-year accelerated cost recovery system for commercial PV systems.” This further alleviates financial risks to the investor and helps to attract more investors to federal agency solar projects.
Reduced Risk and Alleviation of Maintenance Concerns Because the contract is designed so that another party owns the system on the agency’s site, that owner is responsible for O&M. This reduces costs to the Government as well as removes potential distractions to the agency or base’s mission. O&M requires training and education of staff, hiring contractors to regularly review performance, and other asset management. The federal agency simply has to pay utility bills under the PPA, and performance concerns are taken care of by the system owner.
With so much benefit for federal agencies, one would expect PPAs to be more commonplace on the federal level.
The next section will explore why PPAs have a much longer history of use in the private sector.
9. Canavan et al., P5.
With so many benefits for using a PPA, it begs the question of why this financial tool hasn’t been more common at the federal level. A combination of issues has deterred investors and businesses. However, significant government and developer effort has cleared away the obstacles and is creating a winning scenario for all parties.
Complications of Executing PPAs Historically Government regulations limit civilian federal agencies to contracts of 10 years pursuant to Federal Acquisition Regulation 41.103 under the “Acquiring Utility Services” section as well as Title 40 Section 501 in the United States Code. This short timeframe doesn’t allow tax equity investors enough time to earn their return on investment.
Hence, finding a partner for a renewable energy project is more difficult. Furthermore, those investors who are interested typically charge higher rates to minimize their risks, recoup costs, and make a profit. Consequently, the higher rates make the power purchase agreement less attractive to an agency.
Aligning the PPA with Federal Acquisition Regulations (FAR) Along with the contract duration limitation, lack of alignment of the FAR with solar industry best practices has also
impeded the realization of solar power projects. Some of the key issues are as follows:
1) Assignment and Novation. The Government doesn’t allow a winning bidder to sell the contract to another entity. This regulation is a quality control safeguard meant to make sure that the party who won the bid does the work. However, a PPA requires that the developer immediately novate the contract to a limited liability corporation (LLC), which gets sold to a tax equity investor. This step is required because only the investor has the tax appetite to fully take advantage of all the tax credits.
2) Site Access. Site access has been another sticking point. A land use agreement is necessary to give permission to developers and owners to gain access to government property to build and maintain the system. Commercial PPAs typically contain a legal provision of “quiet use and enjoyment” of the property for the life of the agreement.
10. “Subpart 41.1—General,” Part 41—Acquisition of Utility Services (Acquisition Central, Accessed June 2, 2011), https://www.acquisition.gov/Comp/Far/05html/Subpart%2041_1.html.
11. “Services for Executive Agencies,” Title 40 U.S. Code, Pts 501: 2011 (Findlaw.com, Accessed June 2, 2011), http://codes.lp.findlaw.com/uscode/40/ I/5/I/501.
3) Take or Pay. Under a PPA, the host must agree to buy all the electricity generated by the system because the owner rarely has an alternative off-taker. If the agency changes the way it behaves (for instance, deploying troops thereby cutting electrical usage), the system owner still needs to be compensated for the electricity it produces. However, the Government operates on a just-in-time basis to ensure that it doesn’t pay for things it doesn’t use.
4) Termination for Convenience. This FAR allows federal agencies to terminate contracts for convenience, but this stipulation imposes too much risk on investors who would have to pay a significant tax recapture penalty if the contract is terminated within the first six years.