Emerging themes in build-own-transfer agreements
Build-own-transfer agreements — also referred to as BOT or BTA contracts — are playing a bigger role in the renewable energy sector as utilities decide they would rather own projects than enter into long-term contracts to buy the electricity.
In a BOT contract, the developer usually retains the project and bears most construction-related risks until completion. The arrangement is an alternative to another common transaction in which the utility buys the rights to a project at notice to proceed with construction and thereafter bears construction risk.
BOT contracts are signed while the project is still in development and address what happens during three distinct phases: the later stages of development, the construction period and a post-completion period.
Negotiated BOT contracts tend to fall somewhere on the continuum between a purchase and sale agreement (PSA), on the one hand, and an engineering, procurement and construction (EPC) contract, on the other. The arrangement is PSA-like in that it is fundamentally an agreement for the sale of a project — albeit on a deferred basis — by the developer to the utility. At the same time, the parties usually want rights and protections that are more typically found in an EPC arrangement. For example, the utility wants extensive project approval rights and a broad covenant package, while the developer wants EPC-like protections, such as cost and schedule relief for changed circumstances.
BOT contracts vary widely, primarily due to the varied sensitivities and risk tolerances among individual developers and utilities. Project-specific differences can also require bespoke solutions. However, there are common themes.
Late Development Phase
BOT contracts usually have an initial, pre-construction phase that is a time-limited window for the parties to satisfy certain conditions to proceed to the construction phase. If the conditions are not satisfied within the agreed time, then the transaction may be terminated by either party.
Approval of the transaction by the utility’s public service commission is the primary condition that must be satisfied during this stage. The developer will usually require, as an additional condition, that the utility has approved key elements of the project, such as the forms of construction contracts.
Where one of the parties has agreed to bear risks if the transaction moves into construction, it may seek relief if those risks materialize during this initial phase. For example, the utility typically bears change-in-tax-law risk under BOT arrangements, and it will usually want a right to terminate if such a change occurs during the pre-construction phase. The developer will wants similar relief if a circumstance outside of its control arises that would render it unable to satisfy milestone conditions during subsequent phases of the deal.
If the public service commission approves the contract, and the other conditions to move into construction are satisfied, before an outside date, then the transaction progresses into construction.
PSA v. EPC
BOT contracts are a hybrid of a PSA and an EPC contract. This becomes clear during the second phase. It is useful to lay out the two ends of the continuum before pointing out how a BOT contract falls in between.
In a simple PSA, a buyer (here, the utility) would agree to buy a project upon satisfaction by the seller (the developer) of certain closing conditions, primarily delivery of a completed project by an outside date. In a PSA, the developer bears the risk of most adverse developments before the sale, including developments that would render delivery of the project impossible. If the developer fails to satisfy the closing conditions, it receives no payment for its efforts but keeps the project.
In an EPC contract, the contractor (developer) builds the project at the direction of the owner (utility) to the owner’s specifications. The developer is entitled to cost and schedule relief for many adverse developments outside of its control, and is entitled to periodic payments during construction as long as the developer fulfills — or is excused from — its obligations during construction. If the developer breaches the EPC contract, it is liable for damages that effectively reduce the contract price. Only in the most extreme cases would it not receive any payment.
In BOT negotiations, the utility prefers the best of both worlds, meaning it wants the risk allocation and payment terms of a buyer under a PSA but the control over construction of an EPC contract. The developer wants the flexibility and purchase-price premium of a PSA seller while benefitting from the protections typically afforded to EPC contractors. The negotiated BOT contract must land somewhere in between.
An example of how this tension plays out is how the BOT contract deals with schedule delays. In a typical EPC contract, the contractor must keep the construction on schedule. In a typical PSA, the seller is not held to any particular milestone schedule, although it risks losing the sale if it fails to deliver the completed project by an outside date.
A reasonable middle ground for a BOT contract might be for the parties to agree to generous cure periods for schedule delays, but only so long as the project is still expected to be completed on time. This is a compromise between the developer’s desire for flexibility to address construction-period issues without losing the sale, on the one hand, and the utility’s desire for certainty that the project will be delivered by an outside date, on the other.
Developers should be wary of other EPC-like covenants requested by utilities.
EPC contracts have covenants requiring the contractor to avoid doing things that will impose liability on the owner. An example is polluting the project site. Such covenants are arguably out of place in a BOT contract, where the developer remains the owner of the project and project site during construction.
Consideration should be given to the harsh consequences of breaching an EPC contract versus a BOT contract. In an EPC contract, the contractor is paid as it completes milestones, and the owner’s remedies for contractor default are linked to the loss of value or damages suffered by the owner. In a BOT contract, the developer often earns nothing unless and until the conditions to transfer are satisfied, and a developer breach could lead to termination of the contract. In a case of partial performance, an EPC contractor would generally be permitted to retain the payments it has received, except as required to compensate the owner for the loss of value or damages suffered by the owner due to the contractor’s failure to perform fully. In the same scenario, the developer under a BOT contract could be left with ownership of a substantially completed project, but without any arrangements to sell the project or the electricity it generates.
The risk to the developer might be mitigated by agreeing to EPC-like covenants in exchange for an extended cure period — perhaps up to the completion deadline itself — to cure defaults.
However, such a compromise would not address a scenario in which the developer has substantially performed under the BOT contract, but finds itself unable to satisfy the closing conditions and thereby consummate the sale. One way to address this is for the parties to agree to close on the sale so long as the aggregate economic consequence of the breaches does not exceed a pre-agreed threshold, but the utility is permitted to withhold a commensurate portion of the purchase price unless and until the breaches are resolved. Such a mechanism provides the developer and its lenders greater certainty that the closing will occur, while reasonably protecting the interests of the utility via the holdback.
Timing of Transfer
Another area of focus in BOT negotiations is the timing of transfer.
The simplest structure — which is common in BOT contracts for wind projects — provides that the project is transferred, and the purchase price is paid in full, only when the project is satisfactorily completed. This usually happens at “substantial completion.”
This does not work where the utility wants to claim an investment tax credit on the project. In that case, the utility must own the project at “mechanical completion.” The utility pays a portion of the purchase price then and the rest when the project reaches substantial completion.
Some BOT contracts transfer the project at the start of construction, with an upfront milestone payment by the utility and subsequent payments during construction as milestones are met. These contracts are much closer to the EPC end of the EPC-to-PSA continuum and raise a set of unique issues that are beyond the scope of this article.
There are complications with any BOT arrangement that transfers the project before final consummation of the project sale.
One complication is that the developer — and, to the extent the developer finances construction, its lenders — may struggle with allowing the project to be conveyed before payment of the full purchase price. Lender concerns might be addressed if the amount paid at project transfer is enough to discharge the project debt or if the project is transferred subject to the lender’s lien.
The unintended consequences of changing ownership while construction is ongoing present a second complication. The developer needs the ability to direct subcontractors, handle disputes, have access to the site, and so on, to complete its work. These developer rights can create tension with the utility’s interest in protecting itself against exposure to third-party claims after it has acquired the project.
A third complication is: what happens if the sale is not fully consummated after the project has been transferred? To the extent a BOT contract contemplates an asset transfer rather than equity transfer, a simple unwind of the transaction is complicated, as it is easier to re-transfer equity in a project company than to transfer back all elements of a project (including the site, permit rights, project contracts, and so on).
The conditions to closing — and receiving payment — are another key area of focus in BOT negotiations.
The developer is eager to avoid a scenario in which it constructs the project to the utility’s specifications and is unable to close the sale — and thereby recoup payment for its efforts — due to a failure to satisfy all conditions. The concern is significant in all cases, but it is particularly acute if there are limited other uses for the project: for example, if the project is in a location that does not have a merchant energy market.
The developer can mitigate this risk by limiting ambiguity and subjectivity in the closing conditions. One common technique is to is to agree on baselines against which the satisfaction of conditions will be measured.
Another mitigant, discussed earlier, is for the parties to agree that closing can occur even while one or more conditions remain unsatisfied, so long as the aggregate economic consequence of the unsatisfied conditions falls below a dollar threshold and the utility is permitted to hold back a corresponding portion of the purchase price.
Developers should scour the list of closing conditions to ensure that they do not shift to the developer risks that it is unwilling to accept.
The developer’s exposure to liability during the various phases of the transaction is a key area for commercial negotiation.
Both parties want to avoid liability if the project fails to move to construction.
Once the project is in construction, the developer’s liability for failure to complete the project on time is heavily negotiated. The first challenge is arriving at a mutually agreeable evaluation of the actual harm that will be suffered by the utility if the transaction is not consummated, given that the harm is mostly intangible in nature.
The second challenge is reaching agreement on the circumstances in which the developer should have to compensate the utility for that harm.
The developer wants to avoid a scenario in which it has tailored a project to a utility’s specifications, and used its own equity and potentially also borrowed money to fund construction of the project, only to run into an issue during construction that cannot be overcome and, as a result, faces the prospect of not only losing the BOT contract, but also paying a break fee. The developer’s concern is particularly acute to the extent the closing conditions allocate to the developer risks that are beyond the developer’s control.
The developer’s liability to pay indemnities after the project has transferred is also heavily negotiated, with the developer usually seeking to limit its exposure to a percentage of the contract price it received, with that percentage reducing over time. The utility typically seeks certain exclusions from this cap, including for certain fundamental representations. Developers usually agree to limited exceptions, while still capping their aggregate liability at the purchase price received. Some developers buy representation and warranty insurance to protect against post-completion indemnification liability exposure.
Another key topic related to the post-completion period is warranty coverage.
The utility’s right to project warranty coverage is not controversial. The source of the warranty coverage may be, particularly where the developer has engaged third parties to perform the work.
The utility will often seek a wrap warranty from the developer, as well as assignment of any warranties from the developer’s vendors and construction contractors. A developer who engages third-party contractors to build the project wants to limit its warranty obligation to handing over the third-party warranties it receives, with warranty-related issues thereafter resolved directly between the utility and third-party providers.
In cases where the developer agrees to provide a wrap warranty, it should be careful to align its warranty with the corresponding third-party warranties it receives, and should ensure that it retains access to those third-party warranties after sale of the project.
In cases where the developer’s warranty responsibility is limited to transferring third-party warranties to the utility, the developer should ensure that its representations, warranties and certifications do not create a backdoor to warranty-like exposure. For example, the developer should ensure that the project’s satisfaction of construction milestones is certified by the third-party contractor that did the work and not also certified by the developer.