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Surety Bonds for Power Purchase Agreements

What are Power Purchase Agreements?

A Power Purchase Agreement (PPA) is a contractual agreement between an energy developer or power generator, purchaser of energy (the offtaker) and sometimes a separate landowner. However, the landowner and purchaser of energy are often the same party. PPAs are typically used on renewable energy projects such as solar, wind, combined heat and power (CHP) and other types of renewable energy. There are also other variants of PPAs such as Synthetic PPAs, in which no construction takes place, but are merely a financial mechanism to reduce price risks.

This chart shows how a power purchase agreement works. the background is a group of solar panels.

In a power purchase agreement, the developer pays the upfront cost of constructing and installing power generation on a property. In return, the power purchaser signs a contract with the developer to purchase energy at a given cost for a period of time. PPAs are usually long term contracts such as 10 - 20 years. A utility company is also normally involved to connect the power to the grid and supply energy if the constructed system falls short.

PPAs benefit the purchaser by allowing them to have stable energy costs that are often cheaper than they could obtain otherwise in the market. They have little or no upfront cost. The developer benefits by taking advantage of rebates, tax credits and other incentives up front, while gaining steady income over the period of the contract. 

Power purchase agreement can be fairly simple, or very complicated. While many PPAs are set up for the customer or off-taker to supply energy for themselves, PPAs can also be used to generate energy that is sold to others. PPAs also routinely have investors involved. These investors supply the upfront cash to the developer for the development and construction of the project. In return, they receive a steady cash flow from the purchase of the energy. 

Special Purpose Entity

Whether investors are involved or not, the PPAs usually set up a special entity to hold the Power Purchase Agreement. This entity is referred to as a Special Purpose Entity (SPE). These SPEs protect the project from risks associated with the Developer’s other projects. When investors are involved, both the developer and investors share ownership of the SPE. These are very common in PPAs.

What is a Power Purchase Agreement Surety Bond?

Power Purchase Agreement Surety Bonds are a three-party financial guarantee that protects one party in the PPA against the non-performance of an obligation by the other party. These bonds are typically a type of performance bond. 

Seller Power Purchase Agreement Bonds

The most common type of performance bond for a PPA protects the energy buyer (off-taker) from the project not being completed on schedule or not producing the amount of energy specified in the contract. 

The principal on these types of bonds is the seller. In most cases, this is the SPE. The SPE on these bonds is responsible for meeting the obligation guaranteed by the bond. The buyer is the party benefiting from the bond and is referred to as the obigee. A third-party guarantor called the surety is the licensed entity supplying the bond.

This chart shows what a seller PPA bond for the construction guarantees.

In most PPAs, there are two different guarantees covered by bonds or an alternative. One guarantee is written for the construction period. This guarantee is a traditional performance bond that guarantees the cost of construction and compensates the buyer for any delay damages. The second guarantee starts when the construction is complete, and the power generation begins. This guarantee requires the system to put out a certain amount of power to the buyer over the contract terms. 

Buyer Power Purchase Agreement Bonds

While requirements for a seller to post financial guarantees are common in PPAs, buyer surety bonds are less common. When the buyer is required to obtain a surety bond, it is to ensure that the payments are made for the purchase of the energy under the agreement. Because buyers under PPAs are often utilities or large companies, buyer financial guarantees are less common. 

For buyer surety bonds, the buyer is the principal on the bond and responsible for meeting the obligation. The seller is the obligee benefitting from the bond. The surety company is still the outside party providing a financial guarantee for the seller’s obligation.

Alternatives to Power Purchase Surety Bonds

While many PPAs require a financial guarantee, it is often required to be a letter of credit, surety bond, or cash in escrow. Generally, a surety bond is the superior choice for the SPE, if one can be obtained. Because these guarantees are in place for a long period of time, cash and letters of credit can significantly tie up a developer or SPE’s resources. This is cash and borrowing that would not be available to use for other projects. Conversely, surety bonds do not usually require collateral. This allows the entities to use their cash and borrowing for other purposes such growth and operations.

Conversely power buyers may prefer cash or collateral. These instruments are usually easier to draw down as they are typically written on demand. However, sellers may include an opportunity cost in the pricing of the guarantee if cash or letters of credit are required. 

Insurance Policies

Another alternative that should be discussed is an insurance policy that guarantees the output of energy. Although there are a limited number of carriers in the marketplace, paying a insurance premium for a guarantee of power output is often a cheaper solution than other guarantees.

 

Surety Backed Letters of Credit

Another alternative to standard letters of credit is a surety backed letters of credit. These LOCs are similar to a standard LOC in many ways. The difference is that the surety bond company is the bank’s customer instead of the developer or SPE. The SPE signs an indemnity agreement with the surety instead of a loan document with a bank. These arrangements provide many of the traditional benefits of surety bonds in that they do not tie up a principal’s cash, borrowing or other resources. The biggest downside to surety backed LOCs is that the marketplace is limited, and the principal will need to have a significant balance sheet in order to qualify.

Underwriting Bonds for Power Purchase Agreements

While there are many types of PPAs, they are all complex for bond underwriters and a great deal of expertise is required. Underwriters will want to understand the contract itself, cancelation provisions, the structure and financial strength of the principles, length of the guarantee and decommissioning to name a few. 

This chart show five underwriting considerations for writing power purchase agreement surety bonds. In the background are contractors walking through a solar field.

1. The Contract

The first thing a bond underwriter will want to understand is the contract itself. What exactly are they guaranteeing? They will want to know specifically how performance and default is measured. If a default does occur, is the surety allowed to remedy the default, or will the entire bond penalty be forfeited? Generally, PPA Bonds are forfeiture bonds, meaning that if certain energy metrics are not met, the entire bond penalty is due. 

2. Cancelation

Cancelation provisions can change how a bond company looks at Power Purchase Bonds. If these bonds must be non-cancelable for the entire amount of the obligation, they become very risky for the surety bond company. Alternatively, if the bond company has the option to renew the bond each year, the bonds become much easier to write. 

It is common for the contract to require the surety to be replaced before withdrawing completely from liability, even when cancellation exists. Failure to do so will usually constitute a default under the contract. In other words, if canceled, the bond principal will need to find another surety to replace the former on the obligation.

3. Business Structure

What is the structure of the organization or SPE being bonded? This is a very important underwriting consideration. SPEs generally have no real assets. Therefore, in order to qualify for a PPA Bond a surety will need to get comfortable with what outside indemnity and assets are available. This can be done in many different ways. 

Indemnity

The developer and SPE may be required to provide full or limited indemnity in some instances. In those cases both should be ready to provide financial and underwriting information to the surety. While a strong developer or investor balance sheet is often the easiest way to get approval, it is often not possible to get the indemnity of investors beyond what is in the SPE. 

Capitalization

Another method of getting approval for PPA bonds is to capitalize the SPE. Investors or the developer may choose to put adequate funds into the SPE in exchange for the surety writing the bonds. This method can be preferable to both parties because they often have no further indemnity to the surety in the event of default. The downside is that both parties may have additional capital tied up in the SPE for the duration of the project. 

Collateral

Another option is to provide collateral to the surety. Usually, this collateral is in the form of an Irrevocable Letter of Credit (ILOC). The advantage to posting an ILOC with the surety instead of the buyer is that the surety may not require the full amount of the obligation to be collateralized. For example, it may be better to provide the surety with a letter of credit for 25% of the obligation than to provide the buyer with a 100% letter of credit. 

4. Length of the Agreement

Another important consideration for surety bond companies writing PPA bonds is the length of the guarantee or agreement. Shorter contracts are easier to bond than longer obligations. Much can change over time including a company's financial condition, government regulations, demand for energy and many other things. A surety writing a long term PPA bond will look for ways to protect themselves against such changes.

5. Decommissioning

Decommissioning is the process of removing the equipment at the end of the agreement and returning the land to a normal state. Decommissioning should be spelled out in the PPA. In some cases, the power purchaser owns the equipment and is responsible at that point. In other cases, the SPE or developer is responsible for removing the equipment and restoring the land. If the responsibility is on the bonded principal, the surety will want to make sure that capital is available at the end of the project to complete the decommissioning.

What is the Amount of a Power Purchase Agreement Bond?

There are no set standards for the amount of a PPA Bond. The obligation is normally agreed to by the parties, or is a requirement for borrowing money. It is common to have a performance bond for 100% of the cost of constructing the power facility. However, bonds guaranteeing the power output can range from as little as 10% to 100% of damages.

What Do Power Purchase Agreement Bonds Cost?

The cost of a PPA bond depends on the obligation. The performance bond for constructing the power facility is generally 0.5% of the project amount to 2% of the project amount, depending on the financial strength of the parties. You can read more about how performance bonds are priced

For the power and other performance guarantees, it depends on the credit quality. Investment grade companies may qualify for rates as low as 1% of the bond amount per year, but those costs could go as high as 3%, depending on the perceived risk. These bonds are considered high risk. These premiums will be due yearly for each year that the obligation is in place.

Summary

Renewable energy is an important part of the future and PPAs are one tool to make further investments in renewable energy. Power purchase bonds provide a great mechanism for guaranteeing these projects. They hold significant advantages over other guarantees by freeing up liquidity and borrowing. Contact the energy surety bond experts at Axcess Surety today to see how we can help reduce the financial risks of your project.

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