PPA Auctions and the New Mexican Power Market

PPA Auctions and the New Mexican Power Market:Insights and strategies for realizing your development business

George Humphrey, Partner, Orrick, Herrington & Sutcliffe LLPRecognized by Petroleum Economist ExpertGuides 2013 as one of the world’s finest lawyers in Energy; The Legal 500 Latin America 2015 as a leading Projects and Energy lawyer; The US Legal 500 2015 as a leading Project Finance, Renewables and Alternative Energy lawyer. [email protected]

Horacio de Uriate, Partner, Mijares, Angoitia, Cortés y FuentesConsidered one of the five leading lawyers in Energy and Natural Resources in Mexico by Chambers and Partners and as a leading lawyer in Banking by IFLR 1000. [email protected]

Mirec, May 2016, Mexico City

Orrick, Herrington & Sutcliffe LLP | March 2016 2

Overview

• Introduction to the workshop presenters• Drivers of Mexican renewable market• Power Market Overview• PPA Auction• Overview of project document structure• Acquiring a power project in development• Joint ventures• Developing a power project from scratch• Financing documents and Issues• Market prospects going forward


Workshop Presenters

• George Humphrey, Partner, Orrick, Herrington & Sutcliffe LLP• Horacio de Uriate, Partner, Mijares, Angoitia, Cortés y

Fuentes, S.C.


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Mijares, Angoitia, Cortés y Fuentes

Mijares, Angoitia, Cortés y Fuentes, S.C. was founded in 1994, integrating a team of highly qualified lawyers. The firm is part of Affinitas, an alliance of law firms based in Latin America, which since its inception in 2004 has long been regarded as the most prominent network in the region. Affinitas is committed to responding to clients’ special needs in Latin America through a close-knit network.


Driver of Mexican renewables market

• Mexico is rapidly implementing the energy reform, which is dramatically transforming the electric sector

• Mexico’s Federal Electric Commission (CFE) has been contracting huge amounts of natural gas pipeline capacity (some 16 new pipelines) to bring cheap gas from the United States– 75% increase in existing capacity (25 billion cf/day)– Double length of pipelines with 7 interconnects with US

• Converting more expensive diesel and fuel oil fired power plants to natural gas

• Power prices for large industrial consumers have dropped 60%


Driver of Mexican renewables market

• Industrials, seeing electric prices drop, are waiting and seeing how low prices will go– Not willing to enter into 15 or 20 year power purchase

agreements, which is essential for the project financing of greenfield development

– This has frozen development since 2013, with 9 GW of projects prior to the reform put in development limbo

– This makes PPA auctions the only game in town• Electric system’s current reserve margin is over 30% and

expected to reach 40% in the next several years (usually don’t want more than 17%)

• Cheap natural gas should spur large manufacturing and other industrial development (both reducing power prices and providing cheap feedstock)


Power Market Overview

• 2013 Mexican Constitution was amended to allow greater private participation in energy industry, including electric sector– Creation of Wholesale Market– More flexibility with bilateral agreements– Promotes Clean Energy– Goal of cheaper electricity for industrials

• New electric industry law, together with related amendments to existing energy laws, adopted in August 2014



• Changed CFE from a monopoly owner of the electric system to a “productive state enterprise” intended to compete with the private sector– No longer in charge of managing the electric grid, which

now is done by the National Energy Control Center (CENACE)

– No divestiture of generation plants owned by the CFE (owns 85% of generation)

– CFE will still be in charge of transmission and distribution under regulated tariffs and an open access system

• Mexico’s Energy Regulatory Commission (CRE) issues permits to participate in wholesale market (as buyer or seller), set transmission and distribution rates, and manage clean energy certificates (CELs)



• A single entity can only perform one of the activities of generation, power marketing, sales at retail, transmission or distribution, but a parent may have subsidiaries that perform each such activity

• Generators will be able to enter into PPAs (Contratos de Coberturas) directly with participating qualified user (generally, offtakers with initially 3 MW of load or operating under self-supply or cogeneration structures)

• Generators participating in wholesale market will be required to disclose their cost of generation to CENACE

• Power marketers (suministradores) buying power from generators and selling to end users or trading CELs must obtain a permit from CENACE



• Building of new transmission is key (current system is aged and unintegrated in parts), and lack of transmission would keep out new entrants

• CFE is scheduled to release bids for transmission builds this year


PPA Auction

• Results of the first PPA auction were released March 31– Sale of electric energy (15 years from COD) and CELs (20

years)• Industry was surprised at the low prices obtained by CFE

under the auction• 69 bidders with 227 separate bids• PPAs were awarded for 1,619 MW of solar and 364 MW of

wind– Half of those awarded were to project in the Yucatan, which

received a USD 22 MWh price advantage• Average winning price: USD 47.78

– USD 45.15 average for solar and USD 55.39 for wind• Estimated to represent USD 2.6 billion in investment to

construct the projects


PPA Auction

• Largest winners: ENEL (787 MW solar), Vega Solar (500 MW solar), Jinko Solar (188 MW), Energia Renovable del Istmo II (168 MW wind), Sunpower (100 MW solar)

• Auctions are intended as primary vehicle to promote clean energy

• Expected to occur each April for not less than 500 MW of new capacity

• If the Secretary of Energy (SENER) requests, CENACE may hold more than one auction per year


PPA Auction

• New PPA auction has just been announced and guidelines were issued Friday– Winning bids will be announced September 30 with

commercial operation required for winning projects by January 1, 2019


• Long term auctions– Buyers: Basic service suppliers (Suministradores de Servicios Básicos); other Load Points

Managers (Entidades Responsables de Carga) (Service suppliers (Suministradores), Qualified Users Participating in the Market (Usuarios Calificados Participantes del Mercado) and Generation Intermediaries (Generadores de Intermediación)) once a Clearinghouse (Cámara de Compensación) is established

– Bidders: individuals or entities, severally or in a JV• Bidders can present greenfield, brownfield or operating projects of their own or owned by

third parties• The supplier under the PPA must be a Mexican entity

– 15-year term contracts for energy and power; 20 years for clean energy credits– The amount of products to be bought depends on the buyers’ purchase offer– Only clean energy (wind, solar, geothermal, hydroelectric, and other forms of renewable

energy plus nuclear, certain biofuels and efficient cogeneration)

• First Auction Completed in April 2016: awarded 5,385,715 megawatt-hour of electricity and 5,426,454 clean energy certificates

PPA Auction


• Auction process has two stages

– Prequalification

• The bidder must prove financial and technical capacity directly, through its corporate group or through service providers

• Amount of offered products must be defined at this stage

• COD of the project can be regular (± 6 months of standard date) or irregular (-1/+2 years of standard date)

– Irregular bids are subject to the buyer’s purchase offer

• Once prequalified, the bidder must post a bid bond

– USD$90,500 per offer, plus USD$19,600 per MW, USD$9 per MWh and USD$4.50 per CEL

– Economic Bid

• Bidders with reserved capacity or interconnection priority (bidders that are in an advanced stage of the interconnection process) have preference

• A bidder can make several bids, which can be conditioned or excluding

• CENACE awards bids based on a maximization of the total economic surplus (maximización del excedente económico total)

– For evaluation purposes, bids are adjusted depending on the interconnection node

PPA Auction


PPA Auction

• Determination of winning bids by CENACE is based on complex evaluation of the offer price, quantity of electricity, exchange rate, price zone where the project is located, among other things

• If the project produces electricity intermittently, the price for the energy is subject to an adjustment factor that varies by each hour of each month in a year multiplied by the quantity of electricity produced in that hour– Hourly adjustment factor is provided in the bid guidelines

and is based on the price zone where the project injects– Can result in a positive or negative amount in a given hour


PPA Auction

• CELs, equal to 1 MWh, are sold by the project under the PPA for 20 years– PPA requires a specified amount of CELs to be transferred

each year• A tradable certificates structure• The following are required to purchase CELs:

– Qualified users– Retail electric providers– Self-supply users, and– Holders of legacy contracts


PPA Auction

• Minimum CEL Purchase Requirements:– 2018: 5% of obligated party’s total energy consumption– 2019: 5.8% of obligated party’s total energy consumption

• One current problem with CELs is that the laws haven’t established the penalty for the failure to obtain CELs, which makes it difficult to establish a value for them– Project lenders likely to give no credit for CELs until they

can be realistically valued


Form Auction PPA

• Point of delivery (and sale) is the interconnection node between plant and transmission line.

• CFE assumes risk of price differential between interconnection node and load node (Buyers other than CFE may not take on that risk in future bids).


Form Auction PPA

• Project finance:– Seller may create security interests on facility and PPA,

including collection rights. – Equity owners may pledge equity interests in owner– CFE consent (if objective criteria is met) for:

• PPA assignment• Transfer of generation facility, or• Transfer of equity interest in seller resulting in change of

control– Lender has step in rights to cure seller’s default (180 days

cure period)– PPA Governed by Mexican Law– ICC Arbitration – Waiver of sovereign immunity


Acquiring a Renewable ProjectIn Development

• Structure: Asset purchase or project company purchase?– Assets reduce risk of unknown liabilities following purchase– But may be tax or permitting reasons to do project company

purchase



• Purchase Price– Typically, purchase price is broken up in a nominal up-front

payment with additional payments conditioned on achievement by the Buyer of key milestones:• Power purchase agreement (PPA)• Closing and funding of construction financing• Commercial operation



– Payments for the milestone can be a fixed amount or a per MW amount, for example, upon achievement of commercial operation

– May be conditional with a true-up– Key: Cut-off obligation– Key: No assurance



• Due diligence (Reps and Warranties):– Assets

• Want to be sure to get all assets necessary or desirable for project held by seller and all of its affiliates

• Transmission rights• Contracts• Land rights• Permits• Project reports and studies



– Liabilities• Creditworthiness of seller• Want to know universe of all liabilities, which are fleshed

out by reps• Financial statements• Indebtedness• Related party transactions• Legal proceedings• Environmental conditions• No opposition from landowners, indigenous communities,

non-governmental organizations or other persons



• Development of project prior to close (Covenants):– Ordinary course with restrictions on:

• Incurrence of debt• Transfer of assets• Capital expenditures, except to preserve project assets• Creation of liens• Modification of company structure or issuance of new

equity• Hiring employees• Other action or inaction that cause a material adverse

change



• Seller Non-compete• Other Buyer projects• Seller right to information• Buyer’s obligation to develop project• Seller’s right to buy-back project



• Rep survival period:– Fundamental reps: Formation, authorization, good title to

assets, brokers– Statute of limitations: Taxes, labor, environmental

• Caps, de minimus, deductibles, netting, etc.


Joint Ventures

• Good way to enter new country– International energy company or local partner

• Important to clearly define roles and responsibilities including funding obligations


Land Agreements

• Basics: Good wind or solar resource, easy access to transmission with sufficient capacity

• Landowner must have good title– Must get proper approvals from any agrarian lands (ejidos)– Title insurance


Land Agreements

• Rights to use property must be complete– Convert wind or solar to electricity, install turbines, panels,

roads, crane travel paths, access rights, lay overhead and underground cables, meteorological equipment, control buildings, laydown yards, etc.

– Rights to use resource and to noise, vibration, electromagnetic interference and other effects created by project


Land Agreements

• Term: At least 25 years from commercial operation of the project

• Royalty provision should pick up expected revenue sources and be very clear on obligations– Typically a percentage based on “Gross Revenues”; may

also have minimum annual payment– Calculation of royalty very important– Royalty may increase over time


Land Agreements

• No assurance of development• Need comprehensive lender provisions to allow for collateral

assignment, lender step-in rights, notices to lenders, extended cure periods, etc.

• Restoration and Restoration Security


Interconnection

• Under old regime, CFE provided transmission for generator to its nominal owner offtaker

• Could inject and withdraw at any point on CFE’s system at a “postage stamp” rate

• New power reform to be open access, subject to system reliability and technical requirements

• Price zones established


EPC Contract

• EPC v. TSA/BOP Contract• Creditworthy contractor• Make sure turbine or panel is financeable (i.e., proven

technology)• Contract price fixed


EPC Contract

• Change order only in writing; contractor only gets change order to the extent work is adversly affected due to:– Force Majeure– Weather delay days– Owner breach– Change in law


EPC Contract

• If work is separated into a TSA/BOP, make sure no gaps between scopes of work

• Scope of work should be turnkey - not only as specified– Provide “all items reasonably inferable from the intent and

purpose of the agreement”• Perform work in accordance with prudent industry practice, all

laws and best skill, judgment and attention


EPC Contract

• Personnel appropriately qualified, experienced and licensed• Inspection of site and subsurface• Prepare and comply with site security, quality assurance and

health, safety and environmental plans• Weekly meetings and monthly progress reports


EPC Contract

• Owner’s and lenders’ rights to access work and be present for performance tests

• Major subcontractors approved in advance• Anti-terrorism, bribery and money laundering• Hazardous substances• No right to place liens on project• Taxes - import duty exemptions

– Contractor responsible for temporary import of its equipment


EPC Contract

• Schedule– Owner right to suspend or accelerate work– Time is of the essence

• Milestone payments subject to completion certificate, lien waivers, subs paid

• Payments should not be too front loaded– Owner right to withhold and set off– No right of contractor to suspend work if payment dispute


EPC Contract

• Title to work passes with payment (unless tax reason not to)• Risk of loss generally passes with substantial completion• Major Milestones: mechanical completion, substantial

completion, final completion– Delay liquidated damages– Bonus for early completion

• Performance Tests: power curve warranty– Performance liquidated damages for failure to pass


EPC Contract

• Warranties:– Title– General– IP– Design defect

• DNVGL design assessment certificates– Sound level– Power curve


EPC Contract

• Financing provision (estoppel, consent to assignment, opinion of counsel, financials)

• Termination and remedies– Termination for Force Majeure

• Limitation on liability– Exclusion of consequentials, except LDs, confidentiality

obligations and third party indemnification claims– Overall cap on contractor liability and subcaps on delay and

performance LD liability


EPC Contract

• Insurance– Subcontractor insurance

• Confidentiality and public announcements• Assignment• Third party beneficiaries• Governing law and dispute resolution


Keys to Obtaining Financing

• Project fundamentals that are sound:– Developer with proven track record– Solid PPA and EPC– Merchant?– Proven technology– Base case economics that will support financing (1.4x P50,

1x P99)• World is awash in capital looking for a safe, good return


Types of Debt Financings

• Multilateral financing (IDB, IFC)• Development funding institutions (OPIC, NADB)• Export credit agencies (US Exim)• Commercial financing (SMBC, Mizuho, BTMU)• Vendor financing• Local financing/ supplemental VAT financing (Nafinsa,

Bancomex, Banorte)


Key Financing Documents and Issues

• Credit Agreement• Term sheet critical for obtaining key protections, operational

flexibilities and maximum leverage– Want to ensure lenders qualify for preferential withholding

rates– Want streamlined right to do reasonable change orders and

amendments to material project documents



• Notes• Interest rate and FX swap agreements

– Likely will need hedges in place for construction period to cover both changes in LIBOR and currency exposure under PPA, if any, and lease



• Depositary Agreement– Need to set up onshore and offshore accounts to provide

flexibility in moving money among accounts, paying project costs and O&M costs, and converting between U.S. dollars and local currency


Market Prospects Going Forward

• Large load• Opening of power market could provide significant

opportunities in natural gas, wind, solar and geothermal power projects, as well as in developing electric transmission and natural gas pipelines

• Sophisticated developers will establish vertically integrated positions to leverage opportunities across different asset types, trading and selling of hybrid products to industrials


QUESTIONS


Mr. Humphrey’s practice focuses on U.S. and international project development and finance, corporate finance, strategic joint ventures and mergers and acquisitions, especially in the energy industry. Mr. Humphrey has advised on the successful development and financing of power projects, including renewables, totaling over 2,000 MW and USD 2 billion. He also advises on other types of energy projects, such as oil and gas, LNG, methanol, petrochemical and carbon capture projects. In Latin America, Mr. Humphrey has advised on energy projects in Bolivia, Chile, El Salvador, Guatemala, Honduras, Mexico, Nicaragua and Uruguay. In Mexico, among other things, he has advised on power purchase agreements and the proposed acquisition of energy companies. Currently, he is advising on a Mexican petrochemical facility, including natural gas supply from the United States, and a wind power project. His particular focus has been on running the international and national deal teams to get projects closed and helping sponsors learn the business of energy project development and finance.Mr. Humphrey, who speaks English and Spanish, has been recognized by Petroleum Economist ExpertGuides 2013 as one of the world’s finest lawyers in Energy, The Legal 500 Latin America 2015 as a leading Projects and Energy lawyer, and The US Legal 500 2015 as a leading Project Finance, Renewables and Alternative Energy lawyer. Mr. Humphrey may be reached at [email protected].

George Humphrey

PartnerHouston

T (713) 658-6650 E [email protected]

Related practice areas

Energy & Infrastructure Renewable Energy Private Equity Banking & Finance

Education

J.D., University of Florida Levin College of Law, 1994 B.A., with honors, University of Florida, 1991

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Mr. de Uriarte is a partner at Mijares, Angoitia, Cortés y Fuentes, S.C. since 2005.

He provides legal advice to clients undertaking all sorts of energy projects, including their regulatory, corporate, and financial aspects. He has advised numerous Mexican and international companies in the opening of the energy sector to private investment, participating in combined cycle, wind and solar projects, including co-generation and self-supply projects. He has advised clients in connection with the newly established Wholesale Electricity Market and the first long-term auction.

Mr. de Uriarte has also participated in LNG terminals, natural gas pipelines and toll road projects. He has advised lenders and the borrowers in project finance facilities for the funding of all types of energy projects.

He is considered one of the five leading lawyers in Energy and Natural Resources in Mexico by Chambers and Partners and as a leading lawyer in Banking by IFLR 1000. His practice is recommended by sources who highlight his "enormous experience and ability to both identify and mitigate risks for clients in this area.” Mr. de Uriarte can be reached at [email protected].

Horacio de Uriarte

Partner

T +52 55 52017487 E [email protected]

Related practice areas

Energy & Infrastructure Corporate Project Finance Mergers & Acquisitions.

Education

Master of Laws, Harvard Law School, 1999 Law Degree, Universidad Iberoamericana, 1991-1995

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PPA Auctions and the New Mexican Power Market

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