This article is the third of three articles on solar power projects[1] and discusses testing and performance guarantees in the context of engineering, procurement and construction (“EPC”) contracts for solar photovoltaic power projects.

Guarantees that a power generation facility will achieve designated levels of performance and clear financial remedies for a project owner, constitute key requirements for project sponsors. This is especially so for structuring a bankable project and seeking limited or non-recourse project finance. Performance guarantees and associated liquidated damage remedies allow project owners to pass the risk of an underperforming facility to the contractor(s) responsible for designing and/or constructing it. This protection allows the project owner to make up the revenue shortfall for such under-performance so that the project company has sufficient project funds to repay its lenders and earn the expected return on equity. Understandably, the technology type that a power project deploys has a significant impact on the structuring of performance guarantees and the testing used to establish whether a power facility meets such performance guarantees.

Testing and Performance Guarantees

EPC contracts for solar photovoltaic projects, like many power-sector EPC contracts, typically provide for a testing regime that establishes (1) the functionality of the relevant facility or component (“Functional Tests”), and (2) the performance of the relevant facility or component (“Performance Tests”).

Functional Tests usually apply on a pass/fail basis. The relevant facility or component must pass in order to attain certain key milestones (e.g., “substantial completion”).  If the facility does not pass such tests, then the owner would have a right of rejection of the facility under the EPC contract. Given their pass/fail nature, Functional Test failures do not trigger liquidated damages remedies. However, the failure to pass Functional Tests may cause an indirect accrual of liquidated damages if such failures cause a delay in attaining a key milestone with delay liquidated damages attached to it. In this sense, EPC contracts for solar photovoltaic projects do not materially differ from EPC contracts relating to other technology types.  Typical Functional Tests for a solar photovoltaic project include testing of a facility’s ability to continuously provide active power output, reactive power capability, and frequency withstand capability, in each case under relevant operating conditions.

Performance Tests seek to benchmark the performance of the relevant facility or component against a set of pre-agreed performance parameters set out in the EPC contract.  Performance Tests establish a contractual target for the performance of the relevant facility or component which corresponds to the power-supply obligations that the facility owner has under its power purchase agreement (“PPA”) or, where the facility owner does not have a PPA, performance levels required to meet revenue expectations.  Prior to taking over a facility, project owners will want to ensure that the facility will perform such that the seller under the PPA can meet its PPA obligations or merchant revenue projections. Lenders will also wish to know that the facility will perform to a level sufficient to allow the project to earn enough revenue to meet its debt-service obligations.

The performance testing of solar photovoltaic facilities typically focuses on measures of capacity and efficiency. Solar facility efficiency tests often seek to establish the “performance ratio” of a particular facility (i.e., the actual proportion of the relevant facility’s capacity available for export after deduction of energy losses and facility consumption). As our colleagues noted in the May 2015 Energy Newsletter,[2] daily and seasonal fluctuations in solar irradiation, together with variations in cloud cover, haze and other climactic conditions, affect the energy output of a solar facility. As a result, an accurate determination of a facility’s performance ratio requires an analysis period of up to one year. This lengthy analysis period, coupled with concerns over the long-term reliability of solar technology, means that solar photovoltaic projects (unlike many other power projects) usually require Performance Tests to occur both before and after taking-over of the relevant facility.

Performance Liquidated Damages

Performance liquidated damages seek to compensate a project owner against losses that it will suffer over the life of a project as a result of an under-performing plant.  These damages are typically calculated as the net present value of projected revenue losses based on the magnitude of the performance shortfall, usually expressed in MW, the relevant electricity price, and the length of the supply term, or, for merchant facilities, the planned commercial operations period.  In projects where all Performance Tests occur prior to taking-over, the project owner will usually require either the payment by the contractor of performance liquidated damages as a condition to taking-over or the payment by the contractor of performance liquidated damages shortly after taking-over and as a condition to the “stepping-down” of the face value of any performance security after taking-over. This structure allows the project owner to deduct performance liquidated damages from the final payment under the construction contract, giving the project owner strong commercial leverage.

As noted above, in solar photovoltaic projects Performance Tests usually occur both before taking-over and after taking-over (taking into account performance up to two years after the occurrence of taking-over). At each Performance Test the facility should achieve the corresponding performance guarantees. This is problematic for a facility owner because the owner loses significant commercial leverage once it has taken over the facility (for example, after taking-over the facility owner may not owe any further significant payments to the contractor against which it could set off any performance liquidated damages).  Therefore, sophisticated project owners often seek to structure performance liquidated damages such that if the relevant facility fails to meet any performance guarantee prior to taking-over then performance liquidated damages would apply on the same basis as they would if the pre-taking over Performance Tests constituted the only Performance Tests to occur, provided that if during the post-taking over Performance Tests the facility subsequently achieves the performance guarantees, then the project owner will credit some or all of the initial performance liquidated damages back to the contractor. If the facility meets the applicable performance guarantees during the initial Performance Tests but does not meet the performance guarantees during the post-taking over tests, then the contractor will pay performance liquidated damages following the post-taking over Performance Tests.

Alternatively, project owners could address this issue by adopting mechanisms commonly used in other projects. If the relevant facility fails to meet any performance guarantee prior to taking-over, then performance liquidated damages apply on an ‘interim’ basis, with a liquidated damage amount accruing on a daily/weekly basis (reflecting projected interim revenue losses). This would continue until such time as either (i) the facility achieves the applicable performance guarantees, or (ii) the contractor pays the ‘full’ performance liquidated damages (i.e., liquidated damages that adequately compensate the project owner against losses it would suffer over the life of a project as a result of the under-performing plant). With this structure, the contractor will usually have the right to re-perform the Performance Tests in order to establish that the facility can meet the performance guarantees or the contractor can otherwise elect to pay the full performance liquidated damages (if, for example, the contractor has concluded that the facility will unlikely achieve the performance guarantees). If the contractor has not achieved the performance guarantees or elected to pay the full liquidated damages within a certain time frame then the full performance liquidated damages will automatically apply.

Security

Power project owners usually require EPC contractors to provide an on demand bank guarantee, or “performance security”, as a credit-enhancement for liabilities that the contractor may incur to the owner, including liability for performance liquidated damages. Such performance securities are issued by a creditworthy financial institution and backed by a right of recourse by the financial institution against the contractor. Therefore, contractors have an interest in having the face-value of a performance security reduced to zero as quickly as possible.

In projects where only Performance Tests occur, and therefore only performance liquidated damages liabilities arise, prior to taking-over, project owners will normally permit the ‘step-down’ of the face-value of a performance security upon taking over of the project (on the understanding that the contractor will have settled any liability for performance shortfalls prior to taking over). In such cases, the contractor will typically only have continuing liability for the rectification of defects following the occurrence of taking-over and the ‘stepped-down’ face-value of the performance security would reflect this reduced residual liability. In solar photovoltaic projects, where Performance Tests occur after taking-over, and therefore the potential for performance liquidated damages arises, sophisticated project owners will require contractors to maintain the face-value of the performance security at a level sufficient to cover contingent liability for performance liquidated damages until such time as the relevant facility has achieved all performance guarantees or the contractor has otherwise paid any performance liquidated damages due and owing. If a project owner permitted the stepping-down of the face-value of a performance security upon taking-over a facility and a contractor subsequently incurred a significant liability for performance liquidated damages, then the project owner would face an increased likelihood that the performance security would not compensate it for the full value of such liability. Such an event could create a need to seek an arbitral award against the contractor to fully recover its losses.

Conclusion

Natural fluctuations in solar irradiation and other climatic conditions affect the energy output of solar photovoltaic projects such that it might take a significant period of time after completing the construction of a facility to test the facility’s performance. To accommodate the interests of contractors, on the one hand, whilst still ensuring a bankable project, on the other, project owners need to give careful consideration to the structure of the performance guarantees and associated remedies in their EPC contracts for solar photovoltaic projects.