"Don't mess with Texas." Apparently the slogan even applies to liquidated damages clauses.
This morning, the Supreme Court of Texas issued a decision in a drawn-out fight between wind developer FPL Energy and the power marketer TXU Portfolio Management. The dispute originates from power purchase agreements (PPAs) in which FPL failed to deliver enough electricity and renewable energy credits (RECs) to cover its performance guaranty over a period of four years, in large part because of congestion and resulting curtailment orders by ERCOT. TXU initially brought suit for the shortfall, and FPL countered by claiming that the shortfalls were due to curtailments by ERCOT, and that TXU caused those curtailments to occur by failing to ensure that transmission capacity would be available away from the project delivery point. In any event, FPL argued that the liquidated damages for the shortfall amounted to an unenforceable penalty.
At the time of negotiating the PPAs, TXU and FPL agreed by contract that a shortfall in RECs would trigger liquidated damages in the amount of $50 per REC. There was no market for RECs at the time, and so the parties had settled on this damages amount by using the $50 per REC penalty that the Public Utility Commission of Texas could impose on utilities for not acquiring enough RECs. (The parties also agreed to an alternative price of twice the market value of RECs as determined by the Public Utilities Commission of Texas, if any such determination occurred.)
But today the Supreme Court of Texas ruled that the parties' agreed-upon liquidated damages provision amounts to an unenforceable penalty. Although the clause may have been a reasonable estimate of TXU's damages at the time of negotiation--particularly given that the clause mirrored the regulatory penalty for REC shortfalls--the provision failed to reflect actual damages at the time it was applied. The parties' powers of divination had failed them!
In the court's words: "When the liquidated damages provisions operate with no rational relationship to actual damages, thus rendering the provisions unreasonable in light of actual damages, they are unenforceable." In other words, it does not matter that the liquidated provision in the PPA was a reasonable estimate of damages at the time it was negotiated. Instead, what matters is whether the liquidated damages provision at the time it is applied reflects actual damages. As a result, a provision that was once reasonable became invalidated when market values later created a significant difference between the past estimate and actual damages.
To put this in a broader context, not all states approach a liquidated damages provision in this way. In its decision, the Supreme Court of Texas applied the "second-look" doctrine to the liquidated damages clause (despite seemingly starting toward a different doctrine), meaning that the court considered whether the liquidated damages provision was reasonable at the time it was negotiated, and also whether it is reasonable at the time it is applied. A "one-look" state considers only whether a liquidated damages clause was reasonable at the time it was negotiated. If FPL and TXU had chosen in the PPA to apply the laws of a "one-look" state, then the result may have had many differences--tens of millions of differences.
As to how FPL wound up in the shortfall position to begin with, FPL argued that TXU had failed in its contractual duty to provide transmission capacity to deliver electricity away from the delivery point. That failure resulted in higher than expected congestion and resulting curtailment orders from ERCOT. TXU countered that its transmission service obligations were limited to transmission for “Net Energy” - i.e. energy that was first delivered to the Delivery Point. The court agreed with TXU, holding that TXU’s transmission obligations arose only when the FPL-generated electricity actually reached the Delivery Point. The court reached this holding notwithstanding its recognition of FPL’s argument that transmission congestion and ERCOT's related curtailment orders had prevented electricity from reaching the delivery point in the first place.
You may read the court's opinion here: TXU v. FPL.