United States: Combined Cogeneration (and Chiller) Construction Projects

It has been said that smaller on-site cogeneration plant construction projects have many of the challenges of larger power plant projects but on leaner budgets. This may be an exaggeration, but it embodies the point that smaller projects can be complex. The reality is that very few large power plants are being built at this time compared to thousands of smaller on-site cogeneration installations with budgets of $2 million to $20 million.

Although experienced engineering and legal professionals are important to the success of such on-site cogeneration projects, their services must, of course, be cost-effective. For that reason, and because there are no generally available contractual forms that comprehensively address the varied needs of smaller-scale on-site cogeneration, Duane Morris has developed and is continuing to refine a "playbook" for smaller on-site cogeneration projects that includes contracts and other forms.

Cogeneration units, also known as combined heat and power or CHP, produce both electricity and useful thermal energy in the form of steam or hot water. These units can be powered by a variety of fuels such as natural gas, oil, diesel fuel, propane, coal, wood, wood-waste and biofuels such as biodiesel. Types of cogeneration units include reciprocal (like a car engine), microturbine, fuel cells and steam-driven turbines.

The primary advantage of cogeneration is its efficiency; it produces thermal energy that is otherwise discarded as heat from conventional power generation. This thermal energy is used to provide cooling or heating for industrial facilities, commercial applications, large multifamily buildings and other uses. By recycling this waste heat, cogeneration systems achieve much higher efficiencies than conventional fossil-fueled power plants. Cogeneration produces almost 10 percent of our nation’s electricity and saves its customers substantial amounts while providing environmental benefits.

Certain types of generators called synchronous generators can also enhance reliability of cogeneration systems by providing backup power in the event that the utility power grid suffers an outage. Their use is not possible in every situation, however, because utilities may deem synchronous generators unsuitable for certain networks. For example, in portions of Manhattan only cogeneration that is exited by the power grid is permitted.

Due to rising energy costs and competitive pressures to reduce costs and emissions, owners and operators of facilities are actively searching for ways to use energy more cost-effectively. A factor that can lead to the installation of cogeneration is the need to install, replace or upgrade a chilling or heating system. The thermal production of a cogeneration system can make such a combined installation very cost-effective. Regulatory policies, tax advantages, monetary incentives, "green" incentives, the curtailment markets and utility tariff provisions can also encourage cogeneration. Of course, the project and its contractual documentation must be established in such a way as to properly accommodate these cogeneration incentives. For example, it is important for attorneys to understand the applicability, benefits and limitations of utility tariff provisions relating to standby service or distributed generation gas provisions in order to properly advise providers or purchasers of cogeneration.

Structuring On-Site Cogeneration Construction Transactions

Contracts for the provision of on-site generation must take into account that these projects not only have many of the elements of typical construction projects but also variously include provisions relating to equipment sales, interconnection with the local electric and gas utility facilities, operations, long-term maintenance, emergency services, remote monitoring, environmental compliance, compliance with incentive programs, green credits and tax requirements, and availability guarantees. One important element of such contracts is their term, which typically ranges from five to 10 years.

When representing an owner-operator, Duane Morris’ preferred approach is to negotiate for a single provider to take the lead as an "enhanced" general contractor throughout the entire term of the contract. That provider might be an equipment manufacturer who is also acting as a "solutions" company or an energy services company (ESCO). We seek to negotiate a single contract and to develop one point of contact to avoid "finger-pointing" problems that can result from having separate providers of the cogeneration and chiller systems and related services. This process also eases contract administration.

If something goes wrong, disputes as to the allocation of responsibility cannot entirely be avoided, but they can be mitigated in advance by properly structuring and drafting on-site cogeneration agreements that take into account possible allocation issues before they arise. It may also be helpful to "educate" the lender and its attorneys as to the potential downside of protections they believe they require.

Our preferred structure when representing owners includes encouraging them to retain their own engineers rather than to use a design-build approach. Among the important reasons for doing so is the fact that there are many disparate elements for an engineer to address in addition to providing design services, such as performing calculations relating to availability guarantees and local utility standby rates. It is also important for a facility owner to have an engineer on the owner’s side of the table for the purposes of preparing specifications, soliciting and reviewing proposals and participating in the negotiation of the contract and any availability guarantee. In New York state and many other states, an ESCO or provider is required to hire an independent engineer to "stamp" drawings to be filed. The engineer should also be familiar with the requirements of the local utility and applicable incentive providers.

Providers often present to owners their multiple "standard form" agreements covering equipment installation, maintenance, remote monitoring, availability and other elements of the transaction. These presented transactions also often contemplate that the chilling and cogeneration systems will be furnished by separate providers that will each have individual maintenance and monitoring agreements. When the lawyers are brought into the picture by the owner, the client is often in a hurry to proceed in order to achieve a target date. Thus, we may be asked to give a "quick" once-over to a "standard form" of equipment installation agreement with the thought that maintenance, remote monitoring and availability guarantee can be negotiated once the principal agreement is signed. In these instances we work with the client to decide if an alternative approach such as the one discussed herein may be more appropriate, as a serial approach to negotiating contracts will not necessarily favor the purchaser of cogeneration.

We believe it’s important to negotiate all documents simultaneously in order to preserve the bargaining power of the purchaser and to avoid placing the purchaser in the position of negotiating with separate entities. We also seek to advance documents that are commercially reasonable because these are long-term contracts that require mutual cooperation between the parties over time in order to be successful.

This article addresses purchased cogeneration (and chiller) systems¹ which transactions we recommend be handled in a contractually unified manner. A typical set of documentation for a contractually unified on-site cogeneration transaction would include:

Turnkey Construction, Maintenance and Remote Monitoring Agreement. The contract with a single provider includes a basic agreement to which is attached the following schedules:

(A) Project Specifications: These include equipment and construction specifications. Construction within multifamily buildings or hospitals, for example, may also require special noise attenuating structures or panels surrounding the cogeneration units and, where children may possibly have access, systems installed may require a surrounding cage to prevent access. Since many cogeneration systems are installed within older buildings in boiler rooms, demolition and removal of unused boilers and the installation of interfacing equipment for the cogeneration system require the inclusion of asbestos abatement provisions and, in buildings such as multifamily dwellings or educational facilities, lead paint removal or notice provisions. An important part of any such systems specifications are specific requirements for providing training and manuals to the owner/operator.

(B) Milestone Payment Schedule: Most manufacturers acting as providers will seek to "front load" the payment schedule. While we include mobilization and certain fabrication payments, we seek to avoid milestone payments that run ahead of delivery and performance. When the incentives constitute a significant portion of the price of the system and we are representing an owner, we attempt to negotiate "pay when paid" language for owners (although case law generally limits the application of such provisions). Ultimately, we usually achieve resolution with a "delay of payment" provision keyed to the receipt of that portion of the payments relating to incentives.

(C) Special Conditions: We have prepared comprehensive Special Conditions applicable to smaller on-site generation facilities. During the last six months we have successfully obtained acceptance of this form of Special Conditions from providers, including manufacturers. These provisions cover cogeneration-specific issues such as interconnection with the utility, bringing in gas piping from the utility meter to the cogeneration units, and commissioning. Of course, these Special Conditions cover typical construction issues that pertain to onsite generation such as design, contract scheduling, project management, demolition, installation, and other construction-related matters. When representing owners, we include "highest level of performance" conflict provisions that accommodate certain provisions favored by providers.

(D) Maintenance: We cover maintenance comprehensively in this provision, including the cogeneration units and, if applicable, chillers. This maintenance schedule lists the entire system rather than specific pieces of equipment and provides the level of maintenance together with frequency charts. We recommend the highest level of maintenance, even if more expensive, because it supports a longer life cycle and makes it possible to negotiate a stronger availability guarantee. Although typical maintenance agreements will provide that only an authorized provider’s maintenance personnel or subcontractors can perform service, we specify response times and seek to permit owner self-help in emergency situations in which the provider has not responded. These provisions can be complicated because remote monitoring and control will permit the provider to take action in many situations. Another factor to bear in mind is that standard maintenance contracts often include a requirement that the owner report any unusual operating condition. We often modify these significantly since the owner may not have sufficient knowledge to identify such a condition.

(E) Remote Monitoring: Several types of remote monitoring and operation agreement forms are available. These all require the installation of special equipment. The advantage of remote monitoring is that it relieves the burden of the necessity of sophisticated on-site operational personnel and usually permits the cogeneration units to be operated by the existing staff. We also seek to require that the sensors and controls for remote monitoring systems be integrated into the building’s existing energy management system (EMS). This permits the superintendent or other staff members to monitor and operate the entire system by computer. Load-following equipment and controls are often included within such systems so that the generators adapt their output to the demand from the facility.

(F) Substantial Completion and Final Acceptance Certificates: These are typical provisions that relate to other provisions in the contract documents. One important point is whether the warranty provisions commence upon substantial completion or final acceptance in connection with commissioning. Since commissioning requires that the entire system operate properly, significant time may elapse between substantial and final acceptance.

(G) Availability Guarantee: An availability guarantee provides that the cogeneration system will be available a certain number of hours each operational year. "Available" means able to produce power even if the facility does not require it. As you would expect, time is considered for scheduled maintenance or lack of availability caused by the actions or inactions of the owner or force majeure events. Owners can seek to tailor an availability guarantee such that it is consistent with savings to cover amortization of the cost of the system, but such provisions can be difficult to negotiate, especially if the owner seeks a specific dollar performance guarantee.

(H) Incentive Requirements: Federal or state incentives usually require an agreement that the owner take certain actions to qualify for such incentives and remain qualified. To the extent that such actions are to be performed by the provider, our form of contract requires such performance.

We are working on several standalone and combined cogeneration and absorption chiller projects. A good example of a current combined project that illustrates our approach is a large multiple family building that recently closed in which we represent the owner. This cooperative apartment building occupies an entire city block in Manhattan. The necessity of cost-effectively cooling a very large lobby and several other rooms led the cooperative to consider a combined microturbine cogeneration and chiller installation. Multiple dwellings tend to have good load curves (the power demand is more level than many commercial establishments), which means that they can significantly use the output of the system 24 hours a day, 7 days a week. We were successful in negotiating a contract structure whereby the chiller provider, a large international company, is the turnkey construction, maintenance and remote services provider. Given the fact that all such installations have performance elements, it is desirable that the provider have a significant balance sheet supporting its performance.

Driving the decision to install a combined cogeneration and chiller system was that New York state provides a number of advantages that make projects inviting, which advantages also require legal attention. For example, the New York State Energy Research and Development Authority (NYSERDA) provides incentives of up to 40% of the capital costs of approved microturbine installations. In order to access these savings, as discussed above, the owner must enter into a contract with NYSERDA that imposes numerous approval, construction meeting, information-based and other requirements. NYSERDA also provides low-cost loans that can substantially reduce interest costs to owners and, in this case, we helped the cooperative secure a New York State Energy Smart Loan at 4% below the cooperative’s bank’s lending approvable rate. The New York State Public Service Commission (NYPSC) requires gas utilities to offer special lower rates for gas to be used for distributed generation and advantageous transportation costs for gas procured from non-utility sources. On the other hand, the NYPSC also permits the utilities that it regulates to impose standby tariff rates that require owners to gain an understanding of the tariff risks upon self-generation – risks that must be taken into account by attorneys preparing project contracts.

Of course, an important consideration is the cost of gas over the life of the project. While this topic is complex, notably it is possible to hedge an owner’s risk in a variety of ways. In one instance, it proved possible to negotiate a long-term gas supply agreement with an affiliate of a contractor of the provider. This is an example of the benefits of negotiating an integrated agreement that covers all elements of the transaction.

Despite environmental benefits brought about by much greater efficiencies, cogeneration units, except for equipment such as fuel cells, produce air pollution by burning fossil fuels (principally natural gas) or biofuels. These pollutants include particulates, sulfur dioxide and nitrous oxides even though natural gas produces less harmful emissions than many of the other fuels used for generation. Existing and anticipated environmental regulations must be considered and addressed in preparing the project documentation.

Facility owners that consider installing cogeneration need access to the fuels listed above and to experience sizeable daily thermal energy needs such as steam, cooling or heating during a majority of the year. We have clients such as chain grocery stores, with long operating hours and refrigeration costs, that are installing cogeneration. Other candidates might include, but certainly are not limited to, hospitals, nursing homes, hotels, university dormitories, resorts, convention centers and certain high-energy-using industries, including pharmaceuticals, food producers or data centers. In order to serve these institutions or industries successfully and cost-effectively, it is necessary to structure the transaction appropriately.

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris LLP, among the 100 largest law firms in the world, is a full-service firm of more than 600 lawyers. In addition to legal services, Duane Morris has independent affiliates employing approximately 100 professionals engaged in other disciplines. With offices in major markets, and as part of an international network of independent law firms, Duane Morris represents clients across the United States and around the world.