FOUNDERING ON THE ROCKS: NO BUYER MAY SINK YOUR PROJECT
Updated: May 8, 2019
I am often approached by developers of renewable energy projects about new potential projects. They will describe the desirable location of these projects, the fact they have obtained the necessary permits for the project and whatever other approvals are needed, and even why this project, in particular, should be the one from which a utility would wish to buy. These are all good and necessary steps in the life of a project, but they are not sufficient conditions which will allow a project to proceed.
In developing a project, particularly in a region of the country not governed by an organized market with an independent system operator, the necessary and sufficient question to answer is: “who will buy the generation?” In most non-organized markets, utilities are reluctant to do business with independent power projects because the utility does not earn an investment on power purchase agreements with third parties whereby the utility will simply pass on the costs of that power purchase arrangement to its customers. No, the utility wants to earn a return on its investments on behalf of its customers, which means it has more of an incentive to rate base its own assets rather than buy energy and capacity from a third party. There is nothing improper about the utility, as a profit-making entity, attempting to maximize shareholder return per se, except that it can produce maladaptive behavior including rent seeking and monopsony control of the local generation market. It does not have to be so, and it is not always the case, but it can often be the case that utilities simply have no economic incentive to purchase power from independent, third-party generators.
Given these incentives, it is perhaps unsurprising that developers, acting in good faith and with the best of intentions, have their projects stall when they are unable to reach agreement with a utility to purchase the power from their project. This often leaves the developer holding the bag on development costs should the project not be able to find another off-taker or buyer. In situations where the local utility is reluctant or unwilling, this forces the developer to find ways to sell power to an off-system purchaser outside the utility’s service territory, an often expensive and uncertain process in and of itself.
So, the starting point of the due diligence for every renewable energy project should be, “who will buy the power from this project?” Spending money on development including leases, permits, engineering and legal fees, and other development-related costs, may not make much sense until it is clear that there is a market for the power and that it can be sold at a margin that ensures payment of debt service and a decent return on equity. Whether that can be done through negotiation, litigation or otherwise, spending a lot of money on these necessary but not sufficient development steps can often lead to wasted resources for developers. This means the potential buyer must be identified as soon as practicable in the development process, and the path forward clearly staked out. This leads to a discussion of the multiple ways in which the various states have attempted to implement FERC’s legally enforceable obligation regulations, and whether they make sense, but that is, as they say, a topic for another time.