PV Performance Guarantees (Part 1): Page 2 of 8
Inside this Article
Why Performance Guarantees? Why Now?
In the construction industry, there are availability guarantees, operations and maintenance (O&M) contracts and product warranties in abundance. However, PV performance guarantees are somewhat unprecedented. What is unique about PV performance guarantee structures is that they percolate a contractor’s responsibility through a longterm financial arrangement. They do so because PV systems must predictably perform for many years in order to meet the financial expectations for the project.
There is significant competition between project developers in search of investment partners. This means that developers seek to prepare a project with the strongest level of guaranteed revenue in order to increase the likelihood of selling the project to debt and equity investment companies. To achieve this, developers tend to ask EPC contractors for comprehensive guarantees. A strong performance guarantee can centralize the responsibility for meeting many of the perceived challenges associated with a big project and make the whole project more attractive to investors. Large-scale solar is big business, and performance guarantees are big business by association. Almost all large-scale PV projects have performance guarantee contracts.
From the developer’s point of view, it is easier to ask the contractor for a strong guarantee than to convince equity or debt partners that a comprehensive guarantee is unnecessary. After all, the core business of the investor or owner of a largescale PV system is rarely the generation of solar power. Therefore, the EPC contractor is asked to address the performance risk to help ensure that the system is operational for the long term. At the core of any successful guarantee is the idea that the project must be successful for its lifetime. It may sound simple, but very few construction projects have as much at stake. One of the keys to a successful guarantee is balancing the level of coverage with the cost of coverage.
Level of coverage. It is difficult to generalize about the level of coverage that is sufficient for debt and equity providers. Each unique deal requires an individual analysis. However, investors are generally hesitant to pursue projects that are perceived as risky. The challenge is to provide sufficient risk mitigation while still finding room for all of the stakeholders to make money.
Wrapping the necessary risks while providing a reasonable profit is harder than it sounds. The recent economic slowdown has substantially increased competition for large-scale solar development projects. The combination of investors’ growing risk aversion and strong competition for PV projects is shifting the market to where investors insist on very robust guarantees. EPC providers are often left with the dilemma of either offering a strong performance guarantee or simply not doing the job.
Cost of coverage. The true cost of creating and maintaining a performance guarantee is not always disclosed in the EPC contractor’s price for services. There are few risk-analysis tools or industry precedents available, so parties on all sides of the negotiating table are most likely guessing. The costs are sometimes rolled into the overall profit margin associated with the EPC contractor’s portion of the project. When this is the case, it may appear from an accounting point of view that there are hidden costs in the project proposal. This can be a problem for the owner because hidden costs can negatively impact the project’s ROI.
However, too much coverage can also reduce a project’s ROI. In this case, the owner is getting too comprehensive a plan to cover the project’s needs. One of the challenges is that big EPC providers are not organized to solve the small-scale and relatively high-frequency problems common to large-scale PV systems. Finally, monitoring, maintenance and reporting are not typically central to the business of an EPC contractor. Forcing EPC contractors to take on these risks can be expensive and may set the project up for financial failure.
The True Cost of Performance Guarantees
Pricing a performance guarantee can be very difficult. The challenge is to understand the risks and consequences of the system failing to perform. While large integrators may be able to contractually limit their liability, they may also be forced by the owner for commercial reasons to help resolve problems. A classic example is when a large integrator sells a project to an independent power producer (IPP) or non-utility generator, a transaction that may happen soon after the system is commissioned. The site host or energy off-taker may later tell the EPC contractor that the system is not performing as expected and service provided by the IPP is not fulfilling the customer’s expectations. Regardless of whether this claim is valid, the EPC provider may feel obligated to help fix a system that it is no longer contractually responsible for.