On April 11, 2011, FPL Energy, LLC, et al., filed with the Texas Supreme Court a petition for review of the Texas Court of Appeals’ decision FPL Energy, LLC, v. TXU Portfolio Management Company, L.P. The case illustrates the significant economic impact that curtailment can have on variable energy resources. For a detailed description of the case and its implications, see our Renewable + Law Blog entry on the Court of Appeals’ decision here.
The petition for review focuses on the question of whether the Court of Appeals was correct in enforcing the liquidated damages provisions contained in three wind energy power purchase agreements. The pertinent provisions in each PPA required the petitioners to pay $50 for every MWh that the plants fell short of achieving the their minimum REC output guarantees—the Court of Appeals’ holding meant that the petitioners owed TXU roughly $29 million in shortfall damages for a four year period of curtailment imposed by the transmission provider (ERCOT), on top of the pain of losing the contract price and the production tax credit on each MWh of energy curtailed.
Petitioners argue that the Court of Appeals should have held the liquidated damages clause to be unenforceable, as the trial court did, because (1) the $50/MWh liquidated damages amount was based on a regulatory penalty for a renewable energy credit (REC) shortfall that was never imposed on TXU or its assignee, and (2) the $50/MWh sum “exceeds any conceivable damage” actually suffered by the buyer.
The petitioners also argue that the Court of Appeals’ reasonableness determination was based on a comparison of $50/MWh to the bundled market price per MWh (energy plus RECs), rather than the market price for RECs alone. According to petitioners, TXU’s cost to cover the REC shortfall was in the range of $4 to $14 per MWh, not $50, and TXU was able to cover the energy shortfall with coal-fired electricity at $12 to $13 per MWh vs. the $24/MWh price in the PPAs. By giving TXU a windfall, say petitioners, the Court of Appeal’s holding violates the principle of “just compensation.”
I’m sympathetic to the arguments that FPL is making on liquidated damages, but I won’t speculate about how the Texas Supreme Court will finally rule. The case does, however, show that liquidated damages clauses should be handled with care in any negotiation, especially around PPAs. The basic rule is that a provision that sets unreasonably large liquidated damages is unenforceable as a penalty. PPAs with hard-wired liquidated damages amounts (e.g,, $x per MWh regardless of actual market conditions) may be subject to scrutiny and ultimately may not be enforced, especially if a court concludes that the resulting damages look like a penalty. Liquidated damages provisions that use cost-to-cover tied to a market index are much less likely to draw the unwanted attention of a court or arbitrator, since the link to the market will cause the liquidated damages to appear reasonable relative to market conditions.
The petition also challenges the Court of Appeals ruling that TXU only had an obligation to provide transmission services sufficient to accept and transmit the “Net Energy” of the three plants (i.e., the energy that hit the busbar after ERCOT’s curtailments were imposed). The argument seems to be that because TXU was responsible for “purchasing or arranging all services, including without limitation Transmission Services, . . .necessary to deliver Net Energy to TXU Electric’s load from the Renewable Resource Facility throughout the Contract Term,” it had a duty to do whatever it took to obtain transmission services sufficient to take everything the three plants could generate regardless of congestion—even if that meant arranging and paying for substantial improvements to the transmission system to eliminate the congestion problem.
Our litigators tell me that, as a general matter, if you are going to place a multi-million dollar obligation on a party to a contract, you should be really explicit about it, and that’s a good lesson to apply generally in negotiating PPAs. A fair reading of Section 2.03 is that it required TXU to obtain whatever transmission service was offered on the transmission system to take away whatever the plant was able to generation after taking into account ERCOT curtailments, but not—without a very clear obligation in the PPA—that it was obliged to build transmission or pay for curtailments if it didn’t. Of course, that’s just my opinion from afar, and the Texas Supreme Court might take a different view after a careful review of the record.
We’ll continue to monitor the TXU v. FPL appeal and will report on the Texas Supreme Court’s final decision when it is handed down.
On July 27, 2010, the Court of Appeals of Texas, Fifth District, Dallas, issued its decision in TXU Portfolio Management Company, L.P., v. FPL Energy, LLC, et al., 2010 Tex. App. Lexis 5905 (2010). The case arose when three FPL wind farms (the "Wind Farms") located in the McCamey area of West Texas experienced ERCOT-imposed generation curtailments imposed by the Electric Reliability Council of Texas ("ERCOT") during 2002-2005. The Wind Farms had each entered into a power purchase agreement (“PPA”) with TXUPM under which they agreed to deliver a minimum quantity of energy and renewable energy credits (RECs) each year. Because of the deficiencies caused by the ERCOT generation curtailments, TXUPM sued the Wind Farms for deficiency damages under the PPAs. The Wind Farms counterclaimed, asserting that TXUPM materially breached each of the PPAs by failing to insure enough "transmission capacity" to allow the three wind farms to generate and deliver all of the electricity they were theoretically able to generate given wind conditions.
Section 2.03 of the PPAs required TXUPM to arrange for "all services, including without limitation Transmission Services . . . necessary to deliver Net Energy." The Texas Court of Appeals concluded that this provision required TXUPM to supply transmission service sufficient to accept delivery of energy actually generated by the project and delivered to the interconnection point. Contrary to the Wind Farms' argument, however, Section 2.03 did not require TXUPM to make sure there was enough transmission capacity in the McCamey area to make sure that the three wind plants could in fact generate every MWh they were theoretically capable of generating given wind conditions.
This outcome is not too surprising--it would have been very unusual had the Court of Appeals concluded that an offtaker's duty to supply transmission services at the delivery point amounted to an implied duty to arrange for the construction of (very expensive) transmission infrastructure sufficient to avoid generation curtailments. Utilities everywhere can breathe a sigh of relief that the Court of Appeals did not read this duty into the PPAs.
The fact that the Wind Farms had failed to deliver enough output to meet the annual minimum quantities specified in the three PPAs was not in dispute. Since the court concluded that TXUPM had not breached the PPAs by failing to supply transmission capacity, the only remaining question was the calculation of damages.
Stepping away from the court’s decision for a moment, though, it’s worth noting that there's a separate provision that is typically included in PPAs for intermittent renewable energy, and it apparently was not included in the three PPAs in dispute here, perhaps because of their 2000-2001 vintage. An annual minimum output guarantee requires a wind developer to take both mechanical availability risk and wind risk--the plant's output can be reduced below the minimum level if the wind doesn't blow as hard or as often as expected, or if the wind turbines and other equipment are not available as often as they should be. However, these risks are to some extent within the developer's control--wind risk can be addressed by thorough wind studies, and mechanical availability can be managed using the developer’s O&M program. Generation and transmission curtailment, on the other hand, are typically outside the developer's control and can be affected by delays in completing transmission infrastructure, additions of other intermittent resources to the grid, routine maintenance of the transmission system, emergencies and other factors.
Recognizing this, renewable energy PPAs usually provide that curtailed energy is counted as if it were generated for purposes of determining whether a plant has achieved its output guarantees. Although the requisite language is often omitted from utility pro forma renewable PPAs, most utilities are willing to agree if pressed that energy that could have been generated but for curtailment(s) should be counted as if it were generated for purposes of testing the project’s output guarantee. There may be a little scuffling over the proper method for calculating the quantity of energy and RECs that would have been generated “but for” the curtailment, but the real fight is usually over whether the PPA is in whole or in part a "take or pay" contract in which the utility is required to pay for some or all of the output that is actually curtailed. Cf. FPL Energy Upton Wind I, L.P., v. City of Austin, 240 SW3d 456 (2007), reh’g denied 2007 Tex App LEXIS 9306 (Tex App Amarillo 2007) (the Texas Court of Appeals ruled that ERCOT-imposed curtailments are not the same as voluntary economic curtailments by the power purchaser under a PPA and thus are not curtailments that the purchaser must pay for).
In any case, the Wind Plants in this case did not receive credit for curtailed energy under the three PPAs, so the court considered the deficiency as a given and turned to calculating the amount of damages. The three PPAs had hard-wired $50/MWh as the liquidated damage payment due for each MWh of deficiency below the annual output guarantee. This number was based on the per MWh penalty the Texas PUC was expected to impose, as of the time the PPA was entered into, on utilities that failed to secure enough renewable energy. The Wind Plants argued that this amount bore no resemblance to TXUPM's cover damages at the time of the alleged breach and had persuaded the trial court to declare the liquidated damages clause to be unenforceable. The Texas Court of Appeals reversed, concluding that the Wind Farms had failed to prove (1) that a measure of damages was ascertainable when the PPAs were entered into, or (2) that the $50/MWh rate was an unreasonable estimate of TXUPM's actual damages.
Using the deficiency rate of $50/MWh and the Wind Farms' total net deficiencies of 580,465 MWh for 2002 through 2005, TXUPM claimed $29,023,250 in deficiency damages. Bear in mind that these are just the deficiency damages, and thus only a part measure of the pain the plants suffered--they also had to forego a sale at the contract price and lost a Production Tax Credit (PTC) on each MWh curtailed. For utilities that are slow to acknowledge that curtailment risk is an important issue for the intermittent energy developer, this case offers a very succinct $29 million dollar explanation of why developers, lenders, and equity care so much about the topic.