United States: Defense Energy Projects: Latest Trends

In this Industry Current, originally published in Power Finance & Risk, three attorneys at Orrick discuss the evolution of the U.S. Department of Defense's power procurement process and the implications for sponsors seeking DoD power purchase agreements. The authors are Harry L. Clark, a partner in the firm's international trade and compliance group, Christopher Gladbach, a partner in the energy and infrastructure group, and Evgeniya Shakina, an associate in the international trade and compliance group.

The U.S. Department of Defense and each of the three major military service branches are committed to expanding renewables purchases to meet their energy needs over the next decade. The National Defense Authorization Act of 2007 requires that DoD procure 25% of its energy from renewable sources by fiscal year 2025. In 2012, President Barack Obama buttressed this goal by announcing a 2025 renewables deployment goal of 3 GW for DoD.

The service branches have each made significant progress in purchasing renewables from utility-scale projects, including from off-base and on-base (behind-the-meter) projects.

To accelerate this progress, to varying degrees, they are now exploring larger-scale procurements by relying on government procurement offices such as the Defense Logistics Agency. In expanding the scope of renewables purchases, they are moving to a more comprehensive "systems installation" approach as well as aggregation of several projects (for service to multiple locations) in one solicitation.

These approaches could involve a combination of on-site and off-site generation, micro-grids and, potentially, energy storage facilities. While creating an interesting opportunity for developers, the move to "systems installation" and project-aggregation approaches creates certain challenges beyond the usual set of risks related to government contracting that developers and financing parties need to consider. This article highlights some of those key issues as well as other unique issues and risks associated with these types of projects.

Project Timing and Coordination

The government does not act like a private party in procuring goods and services. In general, (1) the government is often slow, and delays are frequent; (2) government approvals take time and necessitate coordination among a number of parties; and (3) apart from a few persons inside specialty agencies, the government has little experience or expertise relating to renewables projects or third-party project finance.

As an example of the approval and coordination challenges, for a typical behind-the-meter solar project, the developer may have to negotiate a PPA with one government agency and a site-land lease with another; the developer will also need the support of the relevant installation leadership. This same developer will then have to get approval of the PPA package from the Office of the secretary of Defense, which, if not coordinated appropriately, can result in significant additional delay.

That said, DoD has gained broad experience recently on renewable projects and has learned some lessons. Each new project takes less time and involves fewer government-specific challenges than the last. DoD agencies are proceeding in a more coordinated way. Agencies such as DLA that have already been in charge of multiple contracts have significantly improved their relevant processes over the last several years and reduced project delays (but, of course, there is room for further improvement).

In pursuing amalgamated projects for multiple installations, the service branches will need to take special care in ensuring that the multiple projects are coordinated centrally and the approval process is streamlined. Otherwise, the risk of a development delay may be too high for a developer to absorb.

Guaranteed Energy Purchases and Minimum Annual Production

Most DoD PPAs include commitments that the government as the power purchaser will pay for a minimum annual production level per year. Beyond this level, the DoD typically commits only to pay for energy consumed rather than the total volume of energy produced by the asset (common in the utility PPA market).

For behind-the-meter projects in states without net metering schemes, this effectively means that developers will only build projects that meet the minimum annual guaranty level since there are no assurances that additional generation will be paid for.

For off-site facilities, the developer should have a plan and obtain requisite permits and approvals to sell the energy in excess of the government's consumption in the relevant market.

In parallel, developers generally have to pay liquidated damages to the government if generation does not meet a certain minimum annual production threshold. When negotiating these thresholds, developers should ensure that they allow enough breathing room for project underperformance.

As the government moves to thinking about multiple projects serving multiple loads, these thresholds will continue to assume paramount importance and invite scrutiny by financing parties.

Portfolio Risk

Aggregating multiple energy projects to serve multiple loads creates unique portfolio-associated risk, which needs to be mitigated. Financing parties will seek comfort that multiple projects are sufficiently isolated such that a problem or delay involving one energy project does not jeopardize the revenue from the contract as a whole. Thus, developers and the government will both have to think about how to structure these procurements, including considering events of default and provisions related to single-project terminations (as opposed to overall contract termination).

One method that has been considered is the right to "off-ramp" or "shelve" a project if there is a significant development delay or hurdle to allow the rest of the projects to proceed while parties continue to seek to resolve challenges associated with the shelved project.

State Utilities Laws

State utility laws are critically important for the viability of any given DoD project. For example, a solution involving both on-site and off-site generation delivered to one or more retail loads would only be possible in states that have sufficiently deregulated the energy market and have retail choice (absent some type of a back-to-back or other arrangement with a utility). At the same time, behind-the-meter projects may have limited potential in states that do not allow net metering unless (1) they are sufficiently small such that their output is almost always less than the load of the installation or (2) an appropriate storage facility is created for excess energy.

Also, state utilities laws could impact the structure of the developer's offer. For example, in Texas's deregulated market, the legal owner of generation assets cannot act as a retail electric provider, which necessitates some additional considerations by the developer with respect to structuring the project if a physical load is to be served by the developer's generating asset.

Termination for Convenience

In federal procurement of goods and services—including for energy—the government must have the right to terminate the procurement contract for the government's "convenience," that is, without justification.

As a result, developers and financing parties are often concerned about the uncertainty of their recovery in the event of termination for convenience. One solution is a tailored termination for convenience contract clause that references a standard schedule for party recovery defining the level of recovery for every year during construction and following commercial operation of the relevant project—often called a termination value schedule.

The negotiated termination for convenience contract clause should also account for distributions to all financing parties, including debt and potential tax equity investors, applicable upon a termination settlement. developer will have to take care to include other allowable costs that result from a termination in the contract clause, including make-whole costs for debt repayment and associated penalties and fees, interest rate hedging breakage costs, personnel-related demobilization costs and costs associated with pursuing a termination settlement with the government.

Anti-Assignment Act and Financing Consents

The Anti-Assignment Act generally prohibits assignment of a federal procurement contract without the consent of the government. This creates tension related to the rights of a lender to "step-in" and assume the contract in a default scenario.

To overcome the general ban on contract assignment, the government requires that its acquiescence to an assignment be memorialized in a novation agreement between the government, the contractor and the party to whom the contractor is assigning the contract.

The novation approval process represents additional risk and uncertainty that financing parties must accept. The government can agree to mitigate this risk by allowing financing parties to cure developer defaults through payment of money, and pledges of upstream equity in the project company owning the renewables project are generally permitted.

Developers and financing parties should generally account for additional time and resources needed to negotiate estoppels and financing consents with the government as such consents often are not initially developed or standardized and take time to negotiate.

Changes and Subcontracting

Under developer "prime" project contracts with the government, developers are necessarily acting as a conduit between DoD and subcontractors, and, thus, their obligations to perform under a prime contract should be fully supported by subcontractors' obligations to perform under their respective subcontracts.

With limited exceptions, DoD may make "changes" within the general scope of its contract at any time, resulting in increased costs to the developer. Developers have contract rights to higher upward contract price adjustments to offset cost increases attributable to changes. But the risk of a government short-pay of an equitable adjustment request needs to be appropriately allocated between the developer and its subcontractors.

One method to alleviate developer risk related to changes is to include "pay-if-paid" arrangements pursuant to which the subcontractor gets made whole only if price adjustments fully account for increased costs. There are a number of alternative risk-allocation methods that developers and subcontractors utilize. The developer should also be sure to properly "flow down" certain rights and obligations related to federal acquisition regulations to its subcontractors.

Leases

As mentioned in Part I, for on-site projects at a military installation, the developer will need to negotiate a lease with the government in its role as the landowner.

Government lease forms, which were inevitably created for unrelated purposes such as housing for service personnel, ordinarily require substantial tailoring to serve as reasonable lease arrangements and facilitate financing. It is critical that the developer evaluate lease forms' treatment (or non-treatment) of issues such as lender protections and step-in rights, allocation of risk related to environmental liability, insurance, government property-related access restrictions and lessee indemnification.

Assuming that the trend related to the utilization of multiple on-site projects continues, the government should pursue (and developers should request) a centralized approach to lease negotiations to mitigate time and resource costs attributable to work with standard DoD lease forms. Happily, DoD has recently negotiated several leases for renewables projects with relatively sophisticated developers, so the government now has access to better precedent. It is to be hoped that these improvements come to be reflected in DoD lease forms. 

Buy-American/Domestic Preference Rules

Domestic preference rules apply to utilization of solar panels for DoD power projects. Solar panels must be sourced from the U.S. or another "designated or qualifying country." Designated and qualifying countries include parties to the World Trade Organization Procurement Agreement and countries that have a free trade agreement or qualifying defense procurement arrangements with the U.S.

Notably, China is not party to any of these arrangements, meaning that solar panels for DoD projects generally cannot be sourced from China. Developers must, therefore, consider opportunities for utilizing panels from other countries and potential implications of the use of such panels for project economics.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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