Wanna Buy a Slightly Used Feed-in Tariff Contract?
On November 6, 2019, the Government of Ontario issued Order in Council 1499/2019 directing the Independent Electricity System Operator (“IESO”) to retain an independent third party consultant for the purpose of identifying ways to reduce costs to Ontario electricity consumers, with a particular focus on wind, solar and natural gas contracts expiring during the next 10 years (the “Directive”). In response to the Directive, the IESO retained a third party consultant and issued a report addressed to the Government on February 28, 2020 (the “Report”). The IESO also wrote to and solicited ideas for cost reduction opportunities from contracted generators that held larger IESO contracts or portfolios of contracts. Almost five months later, a copy of the Report, together with the underlying third party consultant report and other related documents, was published last week on the IESO’s public website. After much speculation, the publication finally allows industry participants to see what the IESO and its consultants concluded in response to the Directive.
It will come as little surprise to industry that the Report has few concrete proposals for cost-lowering opportunities. The Report concludes that “buyout” and “buydown” options for wind and solar contracts were the most viable. The “blend and extend” option, which had circulated around industry as the most popularly cited potential cost relief measure, was rejected as unlikely to result in long-term savings to ratepayers.
“Buyout” would involve early termination of a contract in consideration for a lump-sum payment negotiated to represent all future anticipated contractual net revenues to the supplier. The Report identifies the principal risk of buyouts for contract holders (and the IESO) is market forecast related since settling a lump-sum payment requires that each party to the contract assume the risk of its forecast. From the supplier’s perspective, if its actual future market revenues are less than those assumed in the buyout amount, it will have settled for too little and its original anticipated return on investment will be eroded. “Buydown” would keep the contract in place but, similar to buyout, would entail a lump-sum payment in exchange for a lower contract price for the remaining contract term. It may also be combined with or entail financial arbitrage whereby the IESO would provide replacement financing to the supplier. Such replacement financing could also permit the lowering of the contract price payable to the supplier on the assumption that the IESO’s low cost of capital will permit it to provide such financing at a lower cost than the supplier’s existing financing. The Report anticipates that the buyout option will experience less uptake due to the market forecast risk concern, and would not be applicable to gas contracts.
Based on the IESO’s base case scenario, the buydown approach is estimated to result in net cost savings in the first year of implementation of $32 million attributed to wind and solar resources and $5 million attributed to gas-fired resources. The IESO estimates the net present value of the net savings from the buydown option to range from $303 million to $443 million over the term of the program and to require over $2.1 billion of new debt. The IESO also estimates it would take more than a year before cost reductions could begin to be realized by consumers. These estimates do not include the cost to the IESO of the necessary program implementation and contractual changes, and appear to assume that there would be a relatively low approximately 16% take up rate (as a percentage of total contracted megawatts) of the universe of eligible wind, solar and gas contracts.
It will undoubtedly come as a relief to industry that the Report points out that the potential cost-reduction opportunities were screened for, among other considerations, the parties’ respective contractual rights and obligations. Also, vetted opportunities had to be possible under the existing terms of the contracts or achievable through negotiated contract amendments. The Directive and other developments in the sector, particularly the introduction of the White Pines Wind Project Termination Act and the cancellation of the renewable energy approval for the Nation Rise wind project, have contributed to considerable anxiety among IESO contract holders and spread uncertainty to suppliers other than perennially nervous wind and solar generators. The Report rightly points out that, in the absence of supplier defaults, the IESO has few opportunities to terminate its contracts unilaterally. It also rightly – if not understatedly – points out that there are little savings to be had from unilateral terminations by the IESO.
We commend the IESO for the Report on the basis of the reasonableness of its underpinnings for screening opportunities for cost savings, its solicitation and consideration of participant feedback, and the practicality of its analysis and conclusions. Recognition that beneficial opportunities may only be implemented through the agreement of the parties to the supply contracts is an important message to industry participants. As an editorial point, it might have been worthwhile to also remind Report readers that any actions related to unilateral termination of contracts, be they initiated by the IESO or the Government, reduce confidence in the Province’s business climate overall and increase sovereign risk premiums factored in by future investors.
We would also suggest that greater weight be placed on industry anxiety that may have had an impact on the conclusions of the Report. In that regard, we observe that concern about potential unilateral terminations á la White Pines and fears about the IESO actively seeking circumstances to justify contract terminations have continued to dog the industry. These concerns and fears were significantly exacerbated by the Directive and have embroiled industry participants for months. While the Report may help quell some of this anxiety, it will not remove it completely, particularly in the context of the many exacerbating factors arising from the Covid 19 pandemic. (For example, reduction in provincial load and expected increases of provincial debt and deficits.) As a result (but with no empirical evidence whatsoever), we question the Report’s conclusion that buydown would have a higher take up rate than buyout. While buydown may help reduce the consequences of future risk of contract termination, it still suffers from the market risks identified with respect to buyout transactions. Additionally, it contemplates the possibility of the IESO becoming a lender to suppliers. A rhetorical question worth pondering is whether suppliers in today’s environment would feel more or less secure in having the IESO as their lender as well as their offtaker? The Report points out that the IESO “strictly enforces the obligations in its contracts” but that a supplier’s obligations following the achievement of commercial are “generally readily achievable”. We would expect that an IESO financing would increase the supplier’s obligations significantly. We would also expect that most suppliers would perceive a far greater risk of “strict enforcement” by the IESO than they would with their usual financial institutions under their current financings. On the other hand, despite the risk of market forecasting related to the buyout option, there may be significant attraction to a supplier to monetize its contract today and thereby materially reduce any sovereign risk. We would also expect that the transactional costs and the timeframe for implementation of multiple contract buyouts would be substantially less than multiple buydowns combined with financial arbitrage.
In addition to the foregoing potential contractual opportunities, the Report identifies other opportunities for potential electricity consumer savings, including considering the use of non-firm imports to meet future capacity needs, and developing market enhancements to increase competition. More information on associated stakeholder engagements for these initiatives can be found here.
At this point, the ball is back in the Government’s court. While industry may be largely in agreement with the Report’s conclusions, trepidation will continue until the Government’s response is known. We will continue to monitor developments in respect of the Directive and would be pleased to discuss any questions or concerns that arise from it or the Report.