Take-or-pay crisis V2.0: what wind power generators and providers failed to learn from gas pipelines' 1980 dilemma.

• Author: Looper, Scott

1. INTRODUCTION II. WHY TAKE-OR-PAY MAKES SENSE A. Government Subsidies B. High Cost of Natural Gas C. Carbon Tax III. TAKE-OR-PAY MAKES SENSE, AT LEAST FOR NOW IV. THE GATHERING STORM A. Additional Transmission Capacity B. Improved Forecasting V. THE PERFECT STORM A. Protection for Clients B. Contract Negotiations C. Pre-Litigation D. Litigation I. INTRODUCTION

   In the 1970s and early 1980s, natural gas pipelines, trying to correct for severe gas shortages in the 1970s, promised to "take-or-pay" for 80% or more of a producer's gas at the maximum lawful regulated price for terms of at least ten years. (1) By promising to pay a high price for a long term, pipelines would ensure continued investment in new gas exploration and production, and hence, a steady supply of natural gas to meet customer demand. (2) At the same time, however, pipelines assumed all the risk of market decline. (3) As the Fifth Circuit explained,

   The purpose of the take-or-pay clause is to apportion the risks of natural gas production and sales between the buyer and seller. The seller bears the risk of production, To compensate seller for that risk, buyer agrees to take, or pay for if not taken, a minimum quantity of gas. The buyer bears the risk of market demand. The take-or-pay clause insures that if the demand for gas goes down, seller will still receive the price for the Contract Quantity delivered each year. (4) Within a few years, these pipelines were suffering for their mistake. The economic recession, cheap alternative fuels, increased supply, and unusual weather patterns reduced demand and, therefore, depressed natural gas prices. (5) Take-or-pay prices remained 20% or more above the price of new natural gas. (6) The pipelines that were stuck with take-or-pay contracts could not purchase cheaper gas without breaching their contracts, and at the price for which they offered to sell gas, they could not unload their supplies, either. (7) Accordingly, most interstate pipelines refused to perform their take-or-pay contracts, opting instead to allow producers to sue for performance. (8) By 1989, the Federal Energy Regulatory Commission (FERC) calculated that more than $44 billion in take-or-pay liabilities had been settled--to the tune of 14.6 cents on the dollar. (9)

   Wind power generators do not appear to have learned from their predecessors' mistakes. Wind producers are, like gas producers in the 1970s and 1980s, entering into long-term, fixed price, take-or-pay contracts with electricity providers. (10) A recent Wind Power Purchase Agreement (WPPA) highlights their folly: a fifteen-year term during which providers agree to take up to 115% of 465,000 megawatt hours (MWh) at $50.00/MWh on-peak during the peak season, $45.00/MWh on-peak during the non-peak season, and $40.00/MWh off-peak. (11) After the generator has delivered 115%, the provider agrees to take additional energy at 90% of the contract price. (12) Furthermore, the provider agrees to take-or-pay for 97% of total generation, with minimum takes of 60% in the first year and 70% for every year thereafter. (13) For each MWh of untaken electricity, even where curtailment is a factor, the provider agrees to pay liquidated damages equal to 90% of the contract price plus the prevailing production-tax credit (PTC)-which the generator would usually receive from the federal government as a tax credit--making it more expensive for the provider to pay than to take delivery. (14) Essentially, then, although there is no minimum requirement, the provider agrees to pay a fixed rate, in one way or another, for almost every MWh the wind generator produces.

   If a spate of litigation were to break out over breached take-or-pay clauses in WPPAs, however, damages are unlikely to be settled for mere pennies on the dollar. (15) Unlike natural gas, untaken wind energy cannot be stored and resold at a later date; it just disappears. (16) Where untaken gas retains its value, allowing for at least a portion of its costs to be recovered regardless of when the gas is purchased, the portion of costs to be recovered with the sale of wind energy is totally lost. (17) Wind power generators cannot therefore recover their losses. (18) Accordingly, a court would likely grant wind generators damages sufficient to cover their average costs, which are substantially more than mere pennies on the dollar. (19)

   This potential problem is not limited to U.S. markets. Although the test case for the looming litigation played out in U.S. courts, companies in countries around the world have entered into long-term, fixed-cost, take-or-pay power purchase agreements with wind generators that create artificial electricity prices. (20) This is especially clear in the European Union, which has set a goal of obtaining 20% of its energy from renewable sources by 2020. (21) European wind generators almost always require long-term, take-or-pay power agreements, (22) and large natural gas finds in Russia and old Soviet Bloc countries are flooding the European market with natural gas. (23) These factors, along with high prices for wind energy, could lead many providers to breach their contracts. (24) The use of take-or-pay contracts in the wind energy industry is therefore one of global concern and one that, without quick resolution, could lead to higher prices, bankrupt wind generators, and slower development of the burgeoning renewable energy industry.

   This article looks at the problem of long-term, fixed-cost, take-or-pay provisions in WPPAs. First, it finds justification for some form of take-or-pay agreement in WPPAs, acknowledging the importance of balancing risk to encourage long-term investment in renewable technologies. Second, it discusses looming technological and regulatory changes that carry the potential to boost each generator's available capacity by 20% or more. This increased capacity will reduce current wind energy costs by at least 20%, enabling new generators to undercut the market, and, potentially, to price existing generators with long-term, fixed-cost, take-or-pay agreements out of the market. Finally, this paper offers suggestions for new and existing WPPAs, ranging from contract negotiations and renegotiations to anticipatory breach. In the end, it concludes that, unless proactive steps are taken today, a pitched battle between wind generators and providers will usher in an era of new (but familiar) FERC regulation.

2. WHY TAKE-OR-PAY MAKES SENSE

   As the Fifth Circuit explained in Universal Resources, take-or-pay provisions are useful for energy generators that would otherwise hold a disproportionate share of the risk of loss. (25) In order to incentivize production, the take-or-pay provision apportions the risk so that the generator can guarantee it will cover its capital costs. (26) Without this guarantee, no one would invest in new wind projects because current economics do not support a market-based model. (27)

   Within the jurisdiction of the Electric Reliability Council of Texas (ERCOT), the amount of energy demanded by customers is fairly constant. (28) For every megawatt (MW) of wind-generated power added to the grid, therefore, a MW of power generated by another fuel source is no longer needed. (29) In an efficient energy market, the first fuel source that will be backed down is the fuel source with the highest marginal cost per MWh. (30) As Chart 1 below shows, wind generation has zero marginal cost, while natural gas generation has the highest marginal cost. (31)

   [GRAPHIC 1 OMITTED] (32)

   However, although wind is cheaper than each of the other fuel sources, it has not displaced their use in the Texas market. (33) This inefficiency may be attributed to two facts: First, wind generation is intermittent, with better generation during off-peak hours at night when the wind blows. (34) Second, most existing dispatchable generators--including the majority of coal, gas, and nuclear generators in Texas--have already fully recovered their capital costs, but wind projects are only beginning to recover their capital costs. (35) In reality, then, the Texas electricity market is better reflected by Chart 2 below, which compares fully cost-recovered, non-renewable fuel-source generators with new wind generators operating at average cost. (36)

   [GRAPHIC 2 OMITTED] (37)

   As should be evident, wind generators, on their own, cannot currently compete in the Texas market and cover their costs. Nevertheless, two factors have enabled wind power to become competitive: government subsidies and the market price of natural gas. (38) A third factor, a carbon cost per ton that will apply to coal and natural gas generators, will make wind power even more competitive. (39) As long as the market remains competitive, providers will be able to pass their costs onto end-users. (40) They will therefore remain willing to sign long-term take-or-pay contracts with generators; (41) and as long as generators know they will cover their investment costs, they will continue to develop new wind projects. (42)

   1. Government Subsidies

      Federal and state governments have designed several mechanisms to subsidize the construction and expansion of wind capacity in the Texas market. The first of these mechanisms provides for either a $21 PTC/MWh for the first ten years of operation, an investment-tax credit (ITC) equal to 30% of qualifying costs, or a cash grant equal to 30% of approved construction costs for new wind projects. (43) For projects coming online during 2012 and 2013, the latter two credits deliver about $30/MWh in cost savings in 2008 dollars. (44)

      The second mechanism permits a five-year accelerated depreciation schedule--referred to as the Modified Accelerated Cost Recovery System (MACRS) by the Internal Revenue Service--to capture 50% of total value, which translates to savings of about 10%, or $10 per MWh. (45) The third mechanism provides for Renewable Energy Credits (REC), which wind generators sell to non-renewable...