Inflation Reduction Act Impacts on Contractor, EPC, and Supply Contracts
With $98 billion allocated to renewable energy production over 10 years, the Inflation Reduction Act of 2022 is poised to give renewable energy projects a major capital infusion that will shape contractor, Engineering-Procurement-Construction (“EPC”), and supply contracts. In addition to extending existing tax credits, the IRA restores the option for developers, including solar and other renewable technologies, to use either the Production Tax Credit (“PTC”) or the Investment Tax Credit (“ITC”). Solar developers, for example, choosing to switch from the ITC to PTC may need to address new concerns from tax equity investors, especially meeting production assurances and maximizing energy generation for the energy facility. For renewable energy facilities using the PTC, the IRA may raise new concerns from tax equity investors and developers. Parties should keep these issues in mind when negotiating and executing agreements with contractors, EPCs, and equipment suppliers (“OEM”).
Background: IRA Tax Credits
Whereas the value of the ITC is fixed at 30 percent of the energy facility costs, the PTC is a per kWh credit for electricity generated at the energy facility and varies based upon the quantity of electricity generated. Under the IRA, the maximum credit amount for the PTC is 1.5 cents per kWh of power generated at the facility if the facility satisfies the applicable “prevailing wage” rates and apprenticeship requirements. [Prevailing Wage and apprenticeship requirements are a major change for the ITC and PTC and boost the value of each credit by 500% in certain cases. The prevailing wage requirements will be discussed in a subsequent article.] For projects using the PTC, financial modeling and engineering analysis will rely heavily on historical data and projections based on the 10-year energy production (kWh) of the facility, rather than the ITC’s focus on properly accounting for system costs under the IRS Code.
Because maximizing PTC returns hinges on increasing kWh production, concerns regarding total energy production and outages over the first 10 years will increase in importance for tax equity investors. Production guarantees by EPC contractors and OEMs may become necessary to backstop PTC tax investor concerns and financial expectations. The PTC, therefore, may place new concerns on solar developers regarding the terms and conditions they negotiate for EPC and OEM contracts.
PTC Impact on Contractor and Supply Agreements
For projects electing the PTC, the following issues may warrant consideration for contractor, EPC, and OEM contracts:
- Production assurances in lieu of cash for energy downtime. To maximize the economic value of the PTCs, tax equity investors may expect contractors and OEMs to provide power output assurances over 10 years. For projects underperforming on power output targets, contract remedies based upon a one-time cash payment might be insufficient. Without addressing system-level downtime by repair or replacement equipment, cash consideration may not cover the long-term impact on economic returns. For certain repair or warranty issues at a PTC-financed facility, “corrective maintenance” work or new replacement equipment might be necessary to ensure continuous power production over the 10-year PTC period.
- Spare Parts. Spare parts for inverters, modules, or any parts and equipment with long lead times may need to be negotiated upfront with OEMs or EPCs. Readily available spare parts and equipment are likely more important in a PTC-financed project to minimize delays for a product defect or certain production downtime matters.
- Performance Guarantees. Tax equity investors may expect EPC and OEM contracts to include performance guarantees based upon annual kWh targets to make the Project Company “whole” should generation fail to meet the performance guarantee. An Availability Guarantee – as commonly used in ITC transactions – may prove inadequate for the PTC, as an uptime guarantee does not ensure power output.
- Third-Party/Insurance Guarantees. Alternatively, contractors or OEMs unwilling to ensure production or performance guarantees should consider partnerships or insurance products with third parties that guarantee production targets. Services and products to meet and sustain production targets might accelerate under PTC projects.
- Upside Revenue Sharing. Contractors and OEMs could negotiate “upside sharing” agreements for energy generation to share revenues in scenarios where the energy facility exceeds a certain production target. Perhaps options to pro-actively align all parties’ incentives to maximize power output are useful, which minimizes the need for penalties or Liquidated Damages.
- Enhanced Warranties. Tax equity investors may expect contractor, EPC, and OEM contracts for projects now claiming the PTC to have longer warranty periods to match its 10-year duration (unlike the ITC’s five-year period). Parties giving service or equipment warranties on individual work could consider providing enhanced warranties to cover warranty defects that impact system-level power output.
- Exclusions to Guarantees and Warranties. Contractors and OEMs must consider appropriate exclusions for areas outside of their reasonable control and what conditions need to be excluded from guarantees and warranties.
- Asset Management and O&M. With better contractor, EPC, and supply agreements, Asset Managers and the O&M provider should have contractual “carrots and sticks” with contractors and OEMs to minimize downtime and maximize energy generation.
Developers claiming the PTC should consider updates to their contract templates or be sure to negotiate key commitments from EPC and OEM contractors to increase the likelihood of larger PTC revenues. All participants should be prepared with contractual terms and templates for their contractor, EPC, and OEM contracts to align within the PTC’s 10-year framework. Clark Hill can assist developers, contractors, and OEMs to update their contractor, EPC, and supply contracts to address new concerns potentially raised by the PTC for solar and other technologies.
The views and opinions expressed in the article represent the view of the authors and not necessarily the official view of Clark Hill PLC. Nothing in this article constitutes professional legal advice nor is intended to be a substitute for professional legal advice.
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