Contracts and lending needs to reflect grid connection risk in Australia

Out-Law Analysis | 11 Dec 2019 | 11:34 am | 8 min. read

Current delays in connecting renewable energy projects to the electricity grid network in Australia need to be reflected in engineering, procurement and construction (EPC) contracts, and be factored into the way risk is allocated and priced by financiers of those projects too.

Regulation has been tightened in recent times to ensure the security of supply of energy in Australia is not compromised by the shift away from relying on a few major power stations for generating electricity to a much more decentralised system underpinned by local renewable projects.

The resultant effect, however, is potential grid connection delay. There are clauses developers can insert into contracts at the outset to account for the risks that delays present, and further ways in which the contracts can be managed during the delivery phase. There are changes too that lenders need to make to how they approach risk.

A changing market brings complications and delays

Increased investment in the renewable energy sector has led to a strain in the existing grid infrastructure covering the eastern and south-eastern states of Australia, with certain areas experiencing greater delays than others. While Australia has one of the largest interconnected electricity markets in the world, the current rate of connection of new generation assets of different classes into that market creates great complexity.

Large-scale introduction of intermittent renewable energy – 'non-dispatchable energy', distributed energy resources and early withdrawal of traditional baseload generation is forcing the renewable energy industry and regulators, such as the Australian Energy Market Operator (AEMO), as well as network service providers (NSPs) to face the effects of unstable grids.

It has been recently reported by the Clean Energy Investor Group that AUS$1 billion ($684m) has been wiped off the value of wind and solar assets in the past two to three years in Australia due in large part to the country's choked power grid.

Grids are becoming congested as renewable generation continues to occur in regions where grid infrastructure is built for distribution to a local market.

As a result of these complexities and triggered by the south Australian 'system black' event of 28 September 2016, the Finkel review into the future security of the national electricity market was commissioned by the Council of Australian Governments, the forum that brings together the federal government with the governments of the country's six states and two mainland territories, as well as local government representatives.

Among a number of recommendations, the Finkel review proposed that there be stronger governance of the network.

Developers, owners and EPC contractors are facing more detailed and complex registration, commissioning and testing processes as a result of the attempts by regulators and service providers to manage the strain, and this is leading to significant delays and increased costs in projects.

The federal government has recognised the significance of this issue. On 31 October it announced an investment of a further AUS$1 billion ($684m) to establish a grid reliability fund which will invest in energy storage projects, transmission and distribution infrastructure and grid stabilising technologies.

Issues relating to instability of the grid are being heightened by an increased number of generators attempting to connect to the grid and increase generation. Work is bottlenecking at the review and approval phases. Renew Economy recently reported that "AEMO has warned that full commissioning could take up to 18 months in some cases".

Considerations prior to executing EPC contract

To address the issues that are arising, EPC contracts should provide clarity, to the extent possible, around the responsibility of each party in connecting to the grid along with a clear risk profile for the consequences of any resulting delays.

There are a number of ways this can be achieved:

  • consider breaking down connection processes into very clear task-based key performance indicators (KPIs) for each party and programming in realistic timeframes for interaction with regulators;
  • consider more up front engagement with regulators and due diligence on other third party generating assets likely to impact on the network to ensure realistic timeframes are programmed in;
  • consider delay event drafting. Contractor extension of time entitlements for specific regulator delay events could be provided for to the extent these are not caused, or contributed to, by the contractor and they could be linked to agreed KPI obligations. This should be weighed against providing contractor entitlement to any or no regulator-caused delays. Thought should also be given to the extent any 'change in law' relief under the EPC contract will apply to any changes made to rules, interpretation of rules or methodology by regulators.
  • consider the operation of concurrent delays and how any entitlement exclusions will affect the contractor's entitlements to an extension of time for regulator-caused delay events, as often it is difficult to determine the exact reason for delay or even identify the extent to which a regulator-caused delay event contributed to the overall delay.
  • remember that it is difficult to draft for all regulator delay events given the imprecise nature of modelling and forecasting non-dispatchable energy, as well as the frequent structural changes in the market. Consider including real time dispute avoidance processes, such as dispute avoidance boards which include technical experts who can help guide the parties in mitigating delays and determine fault-based extension of time entitlements.

Risk allocation in power purchase agreements should be sufficiently flexible to account for the broader risk allocation in EPC contracts.

It is also important that the EPC contract considers risk allocation in relation to data provided by the regulator or NSP. The allocation of risk in that circumstances should reflect the potential for inaccuracies in the information provided, particularly where modelling or hold point testing is to be conducted based on the data.

Before executing an EPC contract, developers should, where possible, lock in the riskiest aspects of registration and connection, and they should also maintain consistent and regular communication with regulators and NSPs throughout the contracting and delivery processes, and obtain assurances from regulators in so far as is practicable.

Parties should also consider setting up working groups to ensure the connection process is constantly monitored.

During the delivery of the renewable energy project

During the testing and commissioning phases of a project, there is almost always a desire or requirement to increase generation as soon as possible. However, where there are issues with the wider grid or the distribution network, any increase to generation increases the risk of instability in the grid.

When a new or upgraded plant is being commissioned for the first time, a number of hold points are generally required to be implemented in the process. At each hold point, the overall output of the plant is restricted to a specific level of power, defined in megawatts. To progress to the next hold point, the relevant regulatory bodies must be satisfied that it is appropriate to do so.

Many of the risks being faced by contractors are outside their control, and can only be mitigated or avoided by third parties, such as the regulatory bodies. Therefore, aside from minimising exposure to risk at the contract negotiation stage, one of the strongest avenues available to contractors is to simply be aware of all entitlements under the contract and remain vigilant with the submission of notices in accordance with the contractual requirements. Similarly it is essential that developers have a clear understanding of this process and engage appropriate technical advisers to assist in both ensuring that the contractor is doing what is required of it –and to the appropriate standards – and that they are assisting in managing the regulator.

To the extent that the testing or commissioning requirements are changed even slightly, this may have a significant impact on the time taken to reach completion. Any individual change on its own may have only a slight impact on the project, but if there are quite a few of these minor changes, the overall impact can be significant.

It is also sometimes difficult to determine whether a changed requirement may give rise to an entitlement under the contract, such as where a change in law clauses is triggered, and whether the change is due to an added requirement being imposed or an apparent or potential deficiency in document submitted. In many instances, the cause of the change may dictate who is responsible for that risk.

Many of the challenges faced by contractors are highly technical. However, to be able to give full effect to the contract, it is important for commercial and legal support teams to have a basic understanding of the fundamental requirements of registration and commissioning and the way in which documents such as the National Electricity Law, National Electricity Rules, Generator Performance Standards and test plans interact and fit together.

Project finance and bankability considerations

Connection risk, including as a result of delay by the AEMO, is a very difficult risk to allocate, price and mitigate in a project finance context. Evidence of this in the Australian market can be seen by the insolvency of the engineering firm RCR Tomlinson in late 2018: an event that was primarily driven by its exposure to connection risk on greenfield solar farms.

The usual liquidated damages regime would not extend to anywhere near a delay of up to 18 months, so those lenders active in the project finance market in Australia need to adopt a different approach to this risk.

In more recent project finance loans in the renewable sector, a delay by AEMO in excess of a certain period of time – or a change in the national electricity market or the interpretation of those rules as it relates to connection to the grid – will result in a review event. A review event gives the borrower and the lenders a period of time in which to consider the economic impact of the delay and devise a plan for addressing the delay without the borrower being in breach of the finance documents. 

Older project finance loans in the renewable energy sector make provision for a material delay in connection as an event of default. This would give the lenders the ability to enforce their security over the project: something that is an extreme outcome given a borrower's inability to control AEMO's actions.

Other approaches to delay in connection involve a combination of lower gearing, contingent equity, higher performance bonding, and/or retention of pre-completion earnings. However, these approaches are costly and have a materially negative impact on the return on investment for equity owners in a project.

The main takeaways for business

  • Parties to EPC contracts should be conscious of pricing and risk allocation for grid connection delays.
  • Project financiers should be cognisant of the risk allocation, pricing and mitigation mechanisms relating to the project, and consider non-traditional approaches to lending / equity issues accordingly.
  • Where possible, EPC contracts should clarify the responsibility of each party in connecting to the grid and lock in the riskiest aspects of registration and connection prior to execution of the EPC contract.
  • During the delivery of the project, commercial and legal support teams should maintain a basic understanding of the registration and commissioning requirements of the project and any entitlements under the EPC contract and at law.

Jeremy King, James Morgan-Payler, Maritza Sibanda and Imogen Rollnik specialise in major projects and renewable energy at Pinsent Masons, the law firm behind Out-Law.