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The Importance of PPA Termination Provisions

Termination and default are monumental events in the life of any contract.  They can permanently sever relationships and significantly impact the financial future of the impacted parties.  This principle is especially true in the context of a power purchase agreement.

A recent case between a power producer and power purchaser demonstrates the importance of the termination and default provisions.  While other provisions certainly were not insignificant, the outcome of the case ultimately rested on the meaning and application of the termination and default provisions. 

–        Background

Producer is a general partnership that owns an electric generating unit (the “Plant”).  Purchaser is a public corporation that purchases or otherwise procures wholesale power for sale to its members.  Producer and Purchaser entered into a PPA for purchase and sale of power from the Plant.

–        Terms of the PPA

Under the relevant terms of the PPA, Producer was required to pay fixed and variable charges.  Included in the fixed charge was a capacity charge designed to recover Purchaser’s capital costs.   Variable charges included a fuel charge associated with Purchaser’s share of the output actually generated.  Payments also included a bonus when the prior year’s actual dispatch hours exceeded a set percent.

In negotiating the PPA, Purchaser requested a guaranty that the Plant would be dispatched as frequently as a baseload facility.  When Producer refused to provide such a guaranty, the parties settled on a compromise known as a “must-run clause.”  Under this clause, if the Plant’s capacity factor fell below a set percent, Producer agreed to cooperate in causing the Plant to be declared a “must-run” facility, as defined by the system operator.

The remaining provision defined the conditions for declaring default and terminating the PPA.  The conditions applied when (i) Producer failed to materially perform the PPA, and (ii) the failure “materially and adversely” affected Purchaser.   As discussed below, the termination clause played a major role in the case’s outcome.

    • The Dispute

After de-regulation of the applicable power market, newer plants became much cheaper to run, as compared to the Plant.  Additionally, as a result of the favorable rates for Producer’s existing fuel supply, it began selling fuel on the market instead of using it for the Plant.  Since economic dispatch of the system operator was based on Producer’s bids, which incorporated its opportunity cost (i.e., current market price), Producer’s bids into the system operator were higher.  As a result, the Plant became less economical and was selected less frequently for dispatch.

Because the economics of the Plant were less attractive, Purchaser became increasingly interested in a buyout of the PPA.   The parties entered negotiations for a possible buyout, but they were unable to reach an agreement.

Thereafter, under the must-run clause, Purchaser demanded Producer to cause the Plant to be declared a must-run facility.  There was conflicting testimony as to Purchaser’s motive for such demand.  Producer alleged that Purchaser made the demand for must-run because it knew others were looking to buy Producer, and conversion of the Plant to must-run operation would make Producer less attractive to potential buyers.  But the terms of the PPA clearly allowed Purchaser to make the demand when the capacity factor fell below the set percent.

In response to Purchaser’s demand, Producer refused to cooperate and did not cooperate to cause the Plant to be declared a must-run facility.  Based on such refusal, Purchaser declared Producer in default and terminated the contract.  Multiple cases of litigation ensued.

–       Court Rulings

Trial court rulings favored each of the parties.  One ruling declared that Producer did not breach the PPA by failing to bid its Plant in economic dispatch at rates that would cause it to be selected for dispatch on a nearly continuous basis.  In support of this ruling, the trial court distinguished Producer’s obligation to make the Plant available for economic dispatch with the purported obligation to have it selected for dispatch.  Because the PPA required the Plant to only be available for dispatch, Producer did not breach the PPA in this respect.

In a later ruling, the court ruled that Producer materially breached the PPA by refusing to cooperate with Purchaser’s demand to cause the Plant to be declared a must-run facility.  In other words, Producer failed to comply with the must-run clause.  After multiple appeals, the trial court was required to determine whether Producer’s breach authorized Purchaser’s termination of the PPA – i.e., whether the breach “materially and adversely” affected Purchaser.

–        The Importance of the Termination Clause

The trial court concluded that Producer’s refusal to comply with the must-run clause did, in fact, materially and adversely affect Purchaser.  The key to the case is the termination clause, which as discussed above, required a showing that Producer materially breached the PPA and such breach “materially and adversely” affected Purchaser.  The court based its ruling on the following findings.

      • Purchaser was deprived of the benefits of the bargain.

As a result of the Plant’s economics, Purchaser was paying several million dollars per year in fixed charges for virtually no electricity.   The must-run clause was, in effect, Purchaser’s remedy in the event the Plant became significantly less economic.  Producer’s breach of the must-run clause deprived Purchaser of this remedy.

      • Purchaser was deprived of the power-supply-planning benefits of must-run operation.

Producer’s breach of the must-run clause subjected Purchaser and its members to the uncertainty of purchasing supply on the volatile spot market, and deprived them of the ability to strive for stability in the rates charged to their customers.

      • Purchaser was deprived of a hedge against highly volatile spot market prices, and of its right to overcome the Plant’s high start-up costs and high bids.

The court agreed that the must-run clause represented Purchaser’s attempt to mitigate against the risks of the spot market.  In other words, if the Plant did not run, Purchaser was forced to rely on other sources such as the volatile spot market for cover.

      • Purchaser was deprived of increased efficiency of the Plant.

When the Plant ran consistently, it did so more efficiently and at a lower heat rate, which reduced the cost of electricity under the PPA, and vice versa.  Because the Plant began to run infrequently, Purchaser’s price increased, and this increase could have been remedied by Producer’s performance of the must-run clause.  As a result, Producer’s breach of the must-run clause deprived Purchaser of the benefits of a lowered heat rate and corresponding decrease in the price of electricity under the PPA.

      • Purchaser was deprived of economic gains.

In the final basis for its conclusion, the court agreed with Purchaser that the failure of Producer to convert the Plant to must-run operation resulted in a loss of economic gains.  To reach this conclusion, the court interpreted the bonus payment (discussed above) to apply only when the Plant was in economic-dispatch operation, as opposed to must-run operation.  Thus, when the Plant was in economic-dispatch operation, the Purchaser was “on the hook” for the bonus payment.  And Purchaser’s refusal to run the Plant in must-run operation deprived Purchaser of the possibility of relief from such bonus payments.

–        Conclusion

In summary, the court ruled that Producer materially breached the PPA and this breach materially and adversely impacted Purchaser.  The case demonstrates the importance of carefully drafting PPA terms, especially terms concerning default and termination.  Because default and termination are such significant events in the relationship of power producers and power purchasers, they can have an enormous impact on any resulting disputes between the parties.  They should, therefore, be crafted to plainly reflect the parties’ intent.

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