Where Does Energy Infrastructure Come From?

The Project Company

For an empty field to become the site of a power plant, a lot of people have to work together. Someone with land has to give the use of it to the project. Studies have to assess the impact of the project on wetlands, floodplains, ecosystems, etc. Engineers have to design the plant to the smallest detail, and local authorities have to engage the community to approve the plans. Equipment has to be brought from around the world and installed on the site by human hands. The grid operator has to connect the resource to the grid. A lender has to finance all of this, and given the volatility of energy commodities, they need the project to have contracted customers already lined up.

A developer’s job is to line up all of these parties. Every party depends on the performance of every other party, and the requirements of one party impact many others in a circular reference. The developer solves these coordination challenges by being the sole counterparty through which every other party interfaces with the project.

That’s a valuable service. The parties are experts in the part they play, but that part is all they know. They can only create value when they all work together, and the developer is the party that coordinates them and unlocks their value.

The developer creates a special purpose vehicle for the project, called the project company. This is a legal entity that exists only for the purpose of developing, constructing, and operating the project. All counterparties transact with the project company, not the developer parent company, though sometimes the parent company, with its stronger balance sheet, provides guarantees for the project company.

The developer may get all of the project company’s shares and then sell some to a risk capital partner, or maybe risk capital buys in at the parent company level. The project company could also be created as a joint venture with another entity.

There’s a lot of money involved here, so handshakes won’t do. The project company’s shareholder agreement legally codifies everything you’d assume about how the project company should operate: the company can’t issue more shares; it can’t do anything but develop, build, and operate the power plant; the rights of shareholders can’t be altered.

One interesting term is that the company can’t sell the power plant. The power plant isn’t so valuable without the right to the land that it’s on, or without its fuel supply agreement, and so on. Those agreements and the physical plant are inseparable, and those agreements attach to the project company, not the physical plant. So selling the power plant really means selling shares in the power plant’s project company.

Agreements are the Assets

You might be surprised how valuable a project company can be even when it has no physical assets and no full-time employees. At the end of development, when all the pieces are lined up and all the agreements signed, the project company’s only assets are PDFs in a free Google Drive account. At the development stage, the project company’s assets are its agreements.

But those assets could still be worth millions or billions of dollars. Imagine a project company that has all the entitlements and local approvals required to build a high-speed rail from Houston to Dallas. The company owns nothing except for agreements, but it’s a very valuable company because the agreements are very valuable.

The value of an agreement depends on its importance. If the project company makes an agreement with a minor vendor, that’s worth a lot less than securing an interconnection agreement, no matter how good the terms are.

In the current environment, the most valuable agreement is the interconnection agreement. There’s a long line of projects waiting to connect to the grid, which is now the biggest bottleneck to a project’s development. Once the interconnection agreement is signed, the wind is at the developer’s back.

The value of an agreement depends on its terms. Price is the most important term, but there are other important ones, like what guarantees are made, who assumes which risks, and which contingencies are defined and what their remedies are.

There are lots of possible permutations to the terms in an agreement, and lots of room for judgment on the tradeoffs between them. There are many edge cases and contingencies that could be defined with a pre-agreed remedy. A simple transaction could have a very complicated agreement.

The complexity of an agreement tends to be proportional to its importance. There’s a real cost to negotiating an agreement, and not just in staff time and lawyer bills. A change in one agreement might require the sponsor to go back to another party to renegotiate or reengineer. And more complicated agreements are harder for the parties to execute.

The EPC (engineering, procurement, and construction), offtake, and loan agreements lock in the vast majority of the project’s capital expenses, revenue, and debt respectively, so they tend to be the longest and most complicated agreements.

In general, agreements should be as simple as possible - certainly simple enough to be understood by the engineers, financial analysts, etc. - while still defining enough edge cases that there won’t be a need to renegotiate later or clarify requirements while the project is in motion.

This is a good place to briefly run through the typical agreements:

• Land Lease Agreement: The developer secures the exclusive use of some plot of land for the construction and operation of the power generation resource. They’d also need the right to access the plot and, during construction, to access an area around the plot (eg. for temporarily placing equipment). Typically this would be for 20+ years and may include an option to extend the lease later.
• EPC Agreement: This agreement secures a general contractor responsible for completing the engineering designs, sourcing and acquiring necessary materials and equipment, and constructing the plant. The EPC is required to complete some scope of work, including completion tests, by some deadline. The developer is obligated to make some schedule of payments and to provide site access, required permits, etc.
• Operations and Maintenance Agreement: This agreement makes some party responsible for keeping the resource available and in good condition once it’s built. The scope of work could include an enumeration of preventative and corrective maintenance for the O&M to perform as well as documentation and analytics responsibilities. Performance guarantees could include a response time for addressing certain faults or an overall availability rate, with penalties for not meeting them.
• Offtake Agreement: A corporate power user or load serving entity contracts to buy power from the developer’s power plant. Typically the buyer contracts to get a fixed amount of power in certain hours at a fixed price. They pay whether or not they actually consume the power. And if the project produces less than the contracted amount in some hour, the operator has to pay some penalty, probably equal to the wholesale price of power at that hour.
• Interconnection Agreement: This is an agreement between the developer and the transmission service provider (TSP) that obligates the TSP to build whatever grid upgrades are needed to connect the new generation resource to the grid.
• Loan Agreement: This is the agreement in which a lender agrees to provide cash for construction and operation of a project. The developer agrees to pay it back with interest.

Allocating Risks

The project is necessarily a collective enterprise, but the parties don’t want to all rely on each other. Every party wants to be able to deal with the project company alone. The offtaker wants to buy power without needing to evaluate the EPC’s credibility or verifying that all the permits are in order. And yet these are relevant risks to the project’s success.

So each agreement is designed, as much as is practical, to insulate the sponsor’s¹ counterparty from the risk of default or non-performance by one of the sponsor’s other counterparties. This is achieved by each major counterparty guaranteeing their performance, and by the project company doing the same.

Let’s think through a practical example. If the EPC’s construction is delayed, there won’t be a power plant to produce power for the offtaker. The offtaker will have to buy power from the volatile wholesale market. Who should be ‘on the hook’ for that expense?

Should it be the offtaker, the one who actually needs the power? They wouldn’t like that very much. The offtaker wasn’t the party that screwed up construction. They didn’t even hire the party that screwed up construction. If offtakers had to accept the risk of construction delays, they’d probably quit doing offtake agreements with projects in development, and instead they’d contract to buy power from already-operating projects².

Should it be the project company, who hired the EPC? The project company of course has no income or liquid assets of its own to buy the power with. The parent company or a lender would have to make a guarantee for the project company.

But of course, the on-time construction of the project is the EPC’s responsibility. If the project is going to be delayed, the EPC should be sweating more than anyone else. So financial responsibility for delays should fall on them.

What actually happens mechanically is that the EPC promises the project company to pay the project company a daily penalty, called liquidated damages, if the project isn’t completed by a certain deadline. The amount of the payment should be the amount that the project would have made if it were operating - probably the daily value of the offtake agreement. This promise comes with a financial guarantee in the form of a performance bond provided by an insurer or bank.

And the project company guarantees the offtaker that it will be financially responsible for providing power, regardless of delays. So if there is a delay, the offtaker would buy the power wholesale and bill the project company for it. But the project company’s bill is covered by the bank-guaranteed delayment payments it receives from the EPC. This way, every party is financially responsible only for their own performance obligations. And none of the project company’s counterparties need to trust each other, they only need to trust the developer.

There are some practical caveats to note. If the delays are the project company’s fault - maybe a permit that they’re responsible for³ needs to be redone - then the EPC doesn’t have to pay for that. There are some contingencies that impact the EPC’s performance obligations but are out of their control - say, a shipping disaster - that are frequently carved out as triggering an extension to the deadline. There would also be a cap on the EPC’s damages liability. These are very high-value issues, so a lot of time and attention goes toward getting them figured out ahead of time.

The classic principle⁴ is that financial responsibility should go to the party best positioned to control or mitigate the risk. If the risk can’t be controlled, responsibility should go to the party best able to foresee the risk. If the risk can’t be foreseen, responsibility should go to the party best able to bear the consequences of the risk, or who suffers most from it.

The Role of the Lender

The lender is unique for being the only party, other than the developer, that takes a hard look at the overall project. Sure, every party will ask some questions and require certain guarantees. The offtaker might want to know who’s doing the EPC. The EPC needs a guarantee that the developer has the necessary easements. But only the lender does comprehensive due diligence on the overall project.

Bank due diligence is important because lenders and developers have very different tolerances for risk. They have different risk models. Developers know that most of their projects won’t pan out, but the ones that do will pay for the losers. Lenders try to never write a bad loan.

For example, the lender needs to review the environmental impact assessments, because while the developer might tolerate a small chance that an assessment has gaps that will lead to a problem arising down the road, the lender won’t.

Not all developers are diligent in drafting their agreements and designing their project. Two projects might look the same on paper - they have all the same agreements secured - but the quality of the paperwork can vary significantly.

An environmental study was done, but the work was shoddy and the local authorities will want it redone. A market feasibility study was done, but the consultant has no track record and the lenders will have trouble getting comfortable with it. The engineering designs are done, but the chosen components won’t integrate well together. Projects with these problems are ‘paper projects’. They exist on paper but lack underlying substance.

This diligence requires the lender to have expertise specific to the type of project. They need to be familiar enough with the typical agreements that they can have a point of view on what guarantees need to be included and what terms are acceptable. Because the lender is the one paying for everything, often the lender’s requirements⁵ are the overriding factor in negotiations between the developer and other parties.

The lender’s diligence requires technical expertise. They need to assess the EPC’s experience, the suitability of the site, the design of the plant, the reliability and interoperability of the equipment, and other technical risks.

The investment required to develop this expertise is partly why banks tend to specialize in certain types of lending. By necessity, much of this diligence work is contracted out to external advisors such as a ‘lender’s engineer’. External advisors are slower and more expensive, but often necessary for ‘box checking’. Lenders will build as much in-house expertise as necessary to minimize costs and time, while preventing duplication of work when outside ‘box checking’ is required.

The Stages of a Project

The three stages of a project are development, construction, and operation.

During development, the developer works to secure approvals and agreements until all the pieces are lined up and the project is ‘shovel-ready’.

Once everything is in place and construction can begin, the developer gives a formal ‘notice to proceed’ (NTP) to the parties. This is the second most important date in the life of the project. This triggers options in the various agreements, such as the land lease option, and it starts certain countdowns. For example, the construction schedule in the EPC agreement doesn’t use explicit dates. Instead the schedule’s deadlines are in reference to the NTP date (eg. “construction will begin within 60 days of NTP”). During the construction phase, most of the risk is borne by the EPC contractor.

Once construction is complete, the developer gives a formal notice that the project is ready to begin commercial operations. This is the most important date in the life of the project. During the operations phase, most non-market risk is borne by the O&M contractor.

There’s a typical order of operations to development. The developer starts by securing an option to lease land at a site that seems suitable. The site is then studied for feasibility, environmental impacts, and grid interconnection impacts. They’d do some preliminary checks before making the agreement, but since the detailed feasibility studies and environmental assessments are expensive, developers want to have the option secured before investing in them. If none of these studies raise issues that would be prohibitively expensive to mitigate, then the developers pursue local authorizations and an interconnection agreement. With those studies, authorizations, and the interconnection agreement in hand, getting the offtake, EPC, and O&M agreements are relatively easy. Finally they take all of this paperwork to a lender who diligences it and gives them a loan.

Development activities are generally sequenced starting with the cheapest work first. If a site will turn out to be unsuitable, the developer wants to discover this as quickly as possible, having made as little investment in the site as possible. For example, it makes no sense to do an expensive endangered species survey before knowing whether the site passes the relatively inexpensive floodplain analysis.

Some developers may choose to run certain activities in parallel. For example they may start all the site assessments at once, rather than doing one at a time, waiting to pass one assessment before starting the next one. This involves greater risk because the developer invests more in the site with less information about its suitability. But it has the benefit of moving the project to NTP more quickly.

The general trend over the lifetime of the project is that each stage involves less risk, but requires greater investment, than the last stage. Take, for example, the very first step in the project, the land lease agreement. The developer negotiates a simple agreement and makes a small down payment. It’s a small investment but carries a large risk because there are still dozens of hurdles for the project to clear, each with a meaningful chance of killing the project. Each site assessment, typically sequenced from cheapest to most expensive, increases the investment but decreases the risk as more potential project-killing uncertainties are resolved. Once all the assessments are complete, it’s time to make the major agreements. These are complicated negotiations with high transaction costs and down payments. Once all the pieces are secured, development is over. Now there are relatively few risks, and they are relatively well covered by insurance and guarantees, but the required investment is much larger because now options are exercised and construction begins.

Each project stage exists at a unique point on the risk / reward curve, and market participants choose the stages at which they participate based on their personal risk preferences. Some developers specialize in securing land, getting local approvals, and advancing in the interconnection queue - and then they sell to other developers. Some companies buy projects at NTP, oversee construction, and then operate them. Some own projects from the beginning of development and well into the operating phase.

Also consider the fact that the environment surrounding the project is not static during the often multi-year development phase. At each stage of development, when the developer is choosing whether to ‘ante up’ and undertake the next phase or to conserve his cash for other more promising projects, he considers changes in the environment.

For any developer, environmental features include the overall health of the economy, inflation, interest rates, and the strength of counterparties. Market prices are of course very important.

The interconnection queue introduces an interesting environmental feature unique to electric power. The desirability of a site depends on the loads and generators that are connected nearby and that are in the queue to connect. As projects in the queue progress or stall, the developer’s project may get more or less valuable.

For example, a nearby competitive generation technology (eg. a nearby battery when you are building a battery) reduces the attractiveness of your site. If the competitive project encounters permitting issues and stops progressing, that increases the attractiveness of your site and makes you more likely to continue to ‘ante up’ on it. And vice versa.

Or if your interconnection study reveals that expensive grid upgrades will be required to interconnect your site, that reduces the attractiveness of your site. But if another nearby project is ahead of you in the queue, they may pay for those upgrades before you. So their progress increases the attractiveness of your site.

The amount of complexity involved in development is incredible, and it’s easy to see why so many people love doing it.