How safe are corporate PPAs?
Bankruptcy analysis has become a central part of due diligence on renewable and other power projects as project developers rely more frequently on corporate PPAs — long-term contracts with corporations to buy electricity — as a source of revenue for their projects.
A significant percentage of power contracts signed in the first half of 2018 for utility-scale wind and solar projects in the United States were corporate PPAs.
The Enron, Worldcom and Lehman Brothers bankruptcies showed that large companies can disappear quickly.
What happens when the power purchaser files for bankruptcy?
The bankruptcy of FirstEnergy Solutions last spring is a good case study.
Falling power prices
FirstEnergy Solutions was driven into bankruptcy by a set of problems that were unique to it. It owned power plants, but they were primarily coal and nuclear plants. Electricity prices have been driven down by cheap natural gas to a level that is making it hard for coal and nuclear to compete. The company was no longer earning enough revenue to cover operating costs.
The company is the competitive side of a business that is divided between a regulated side and a competitive side. The regulated side is the Ohio electric utility FirstEnergy. Both sides of the business are owned by a utility holding company whose shares are publicly traded. The bankruptcy filing had nothing to do with the regulated side or the public company. The only companies that filed for bankruptcy were those that were involved in the competitive side.
Those companies were separate special-purpose subsidiaries that were the owners of the coal and nuclear plants. FirstEnergy Solutions had also signed long-term contracts to buy electricity from independent power projects, primarily for renewable energy.
One of the benefits from a bankruptcy filing is it lets a company like FirstEnergy Solutions that is locked into uneconomic contracts to buy electricity reject the contracts.
There are two types of bankruptcy filings. In a chapter 11 filing, the bankrupt company presents a plan of reorganization that will allow it to get back on its feet economically. In a chapter 7 filing, the company is liquidated.
FirstEnergy Solutions made a chapter 11 filing. This gives it the ability to assume or reject contracts and, in this case, it is attempting to reject its PPA agreements. The company said in the bankruptcy filing that it is losing approximately $58 million a year on these contracts, and it estimates that the losses could be $765 million over the remaining terms of the PPAs. In addition, the company says that it no longer needs the power because of falling demand for electricity.
FirstEnergy Solutions is not the first competitive power supplier to file for bankruptcy. Two other notable examples in the last 20 years are Mirant, the competitive power affiliate of Southern Company, and Calpine, a competitive power company that managed to re-emerge from bankruptcy.
There is enormous power in the bankruptcy court. Bankruptcy is an opportunity to try to reorganize the finances of power companies, but the court has to weigh the conflicting interests of the bankrupt company against those of creditors, contract counterparties and other stakeholders (including regulators and ratepayers).
The ultimate consumers of the electricity — the ratepayers — are unaffected. The bankruptcy court makes it a priority to ensure that electricity is still flowing to the local community under the same terms as before. Employees of the company will continue to be paid.
The parties who are most affected are the creditors of the bankrupt company and contract counterparties.
Unsecured creditors — for example, a bondholder — will stop receiving interest and principal payments after the bankruptcy filing and must wait until a plan of reorganization has been approved by the court to see how many cents they will receive on the dollar. That will play out over a period of time.
Contract counterparties can lose their contracts if the decision is made that the contracts are uneconomic for the bankrupt company.
It is important when entering into a long-term contract to know your counterparty. The market price for electricity can change over the contract term. A contract that looked good to the power purchaser when it was signed can be a bad deal five years later. Make sure the power purchaser is financially sound so that, even though the economics might shift, the company is expected to remain financially sound so that it will not be tempted to file for bankruptcy merely to get out of a few contracts.
In the FirstEnergy Solutions case, the PPAs were just one element in the decision to file. The parent holding company wants to focus on the regulated side, and the point of the chapter 11 filing is to sell the unregulated assets and shut down the nuclear plants.
Look during diligence at the power purchaser as a whole. Does it have a good business? It is solvent? What could happen during the PPA term to cause the company to crash? How likely are those scenarios?
If, despite all of the precautions, the power purchaser seems headed for bankruptcy, review the PPA carefully to see what your rights are under the contract. If the power purchaser is in default, it might give the independent generator certain rights under the contract. For example, the generator may be able to ask for collateral like a letter of credit.
This brings us to the concept of preferences under the bankruptcy code.
Suppose an independent generator gets a letter of credit. If the power purchaser files for bankruptcy within 90 days after providing the letter of credit, that is potentially a preference, meaning any draws could potentially be taken away in bankruptcy.
Therefore, act early in the process. Then sweat out the 90-day period so that whatever collateral is received to ensure performance of the PPA can be retained.
Apart from that, an independent generator has very limited recourse. It should start looking for other potential outlets for the electricity.
Wholesale power sales are subject to regulation by the Federal Energy Regulatory Commission. The FirstEnergy Solutions bankruptcy has illuminated the tension that exists between the regulators who want to flex their muscles and the bankruptcy court, which wants to exercise its jurisdiction. This fight between the regulator and the bankruptcy court has played out before in both the Mirant and Calpine bankruptcies.
The bankruptcy court wants to see the bankrupt company reorganize and wants to enforce the provisions of the bankruptcy code, while FERC wants to assert its power over the sale of electric power and the reasonableness of rates in the filed-rate doctrine, and it is charged with looking out for the public interest.
The bankruptcy court does not care so much about the public interest. Its goal is to see the company reorganize and have the creditors paid. FERC has a broader view. It wants to protect the market and consumers. These competing interests clash in bankruptcy.
These tensions landed before a US appeals court in the Mirant bankruptcy, and the appeals court decided to give primacy to what is good for the debtor.
In the Calpine bankruptcy, FERC was deemed to have a superior interest, and it was given the final say over whether a PPA can be rejected.
No bankruptcy case in the power sector has gone all the way to the Supreme Court to reconcile these conflicting rulings.
The bankruptcy court in the FirstEnergy Solutions case is following the precedent set in the Mirant bankruptcy. The decision has been made to focus on what is best for the debtor without giving much weight to the effects on third parties and the power markets generally.
The court said the debtor is free to exercise its business judgment to decide to reject the contracts. That decision is being appealed by FERC and some counterparties to the PPAs to a US court of appeals.
The Federal Energy Regulatory Commission takes the position that a PPA for the sale of wholesale power cannot be rejected in bankruptcy without involvement by FERC and that a bankruptcy court cannot approve such a rejection.
Any independent generator that is facing rejection of a power contract after the power purchaser has already filed for bankruptcy should do three things.
First, it should urge FERC to take an active role in the proceedings. Second, it should try to persuade the bankruptcy court to follow the Calpine precedent of ceding jurisdiction over the fate of any wholesale PPAs to FERC. Third, it should argue, if the bankruptcy court insists on retaining jurisdiction over the PPAs, that the standard to set aside such contracts should take into account the public interest, including the impact on independent generators. Could there be a ripple effect of other bankruptcies as independent power projects whose contracts are set aside are forced themselves into bankruptcy? These issues are being played out in the FirstEnergy Solutions case.
In addition, the independent generator should analyze what rights it has under the contract after a breach by the power purchaser. It may have a right to liquidated damages, and the damages could be substantial depending on how many years are left in the contract term. It may be able to negotiate a dollar amount for its claim if there is no formula in the contract. If not, then it will be up to the bankruptcy judge to determine damages.
The generator could end up with a very large damage claim, but how much it will actually be paid is another story. In chapter 11, secured creditors are paid first. Next come administrative claims for such things as employees and people supplying goods and services during bankruptcy. Unsecured creditors come last. Any damage claim under a rejected PPA is an unsecured claim.
To put this into context, FirstEnergy Solutions filed with $3.5 billion of funded debt. The unsecured creditors will be behind the portion of that debt that is secured and will have to share ratably in what is left. It is too early to tell how much money there will be to split among all the creditors with claims against the company.
As the market moves to corporate PPAs, one thing to think about is whether it is possible to get collateral from the power purchaser to secure performance. Such collateral should withstand bankruptcy.
There are other things an independent generator can do. Think about a liquidated damages provision to avoid having to litigate in the unfortunate event the power contract is breached. Address who gets benefits that might otherwise belong to the power purchaser when the contract is terminated.
The enormous claims arising out of the wildfires that ravaged California last year are causing people to worry about what might happen to Pacific Gas & Electric. There have been determinations that falling power lines may have ignited some of the wildfires. Under California law, there is strict liability for power companies in that situation. The damages resulting from the fires have been in the billions of dollars. There has been loss of life, thousands of homes were destroyed, and various aggrieved parties are filing claims and lawsuits against PG&E.
PG&E has said publicly the claims could total $15 billion, and whether it would have the capacity to pay those claims is a big question. Whether it has the inclination to litigate all of those claims, which would be a very expensive and draining process, is another question. How much insurance the company has is another unknown.
PG&E had said publicly that it was considering a bankruptcy filing, as bankruptcy is a good forum to deal with tort claims of this nature.
PG&E has a large number of power contracts with independent generators that could face rejection in bankruptcy. However, a new law signed by the government in September may obviate the risk that PG&E will file for bankruptcy. The new law allows utilities to issue rate-recovery bonds to help pay the tort claims, with the ratepayers paying off the bonds through a surcharge on their bills. (For more details, see the “California Update” in this issue.)