* The following article originally appeared in the September issue of Marijuana Venture, available online.
The cannabis industry consumes enormous amounts of energy to power lighting, climate control, drying and curing operations. Industry-wide, annual energy costs reach into the billions of dollars. This much is clear, energy costs have a significant impact on a producer’s profitability and competitiveness.
As more states legalize marijuana for medical and recreational use, the competition for ever-shrinking margins will only intensify. But with the right energy strategy, growers can both reduce energy costs and increase operational efficiency. One approach is on-site generation using small combined heat and power (CHP) facilities to generate electricity and useful heat for increased reliability, higher-quality power and even the ability to go off-grid. While technical consultants can help assess efficiencies and design an effective CHP system, key legal considerations also must be taken to account.
Structuring the Deal
There are several ways to structure CHP project development, each with its own set of accounting, tax and other legal issues. One basic approach is to hire a third party to develop and build the system, who then transfers it to the customer. Because this impacts the customer’s balance sheet, a second more popular approach is to have the third party own and operate the system, charging a monthly service fee for the energy consumed. This frees up capital and avoids the extra hassle of operating and maintaining the system. It may also require that the customer grant a property lease or easement for the location of the system, which can add additional complications.
Design and Performance Risks
First and foremost, the CHP system must be designed to meet the needs of the customer. The equipment and configuration of the CHP project must be carefully specified, as well as how it is to be integrated with the customer’s existing operations. The system must supply all instantaneous thermal and electric needs to a defined “peak” capacity. There must be no unexpected downtime of the facility and a minimum amount of electricity must be generated. The quality and quantity of thermal energy (heat, pressure, volume) must be assured. As a result, agreements should be crafted to address the customer’s precise needs with clear guidance on performance expectations, ways to measure service failures, and specific remedies when performance standards are not met.
Small deviations in performance are expected and can be addressed through periodic “true-ups” – liquidated damages payments to account for minor issues that arise over the years. This allows the parties to course correct during the life of the contract without terminating the agreement altogether. However, major service failures require significant remedies. Cover damages may be paid if the customer has to purchase replacement energy from its local utility. Another option is to negotiate the right to “step-in” to complete a project still in development, or the right to purchase the operating CHP system at its then-depreciated value.
Timing Risks
Sometimes, timing truly is everything. Because of uncertainties inherent in the project development process, customers need some level of imbedded assurances that the CHP system will start operations when and as agreed. These may include deadlines for the third party developer to meet certain engineering and procurement milestones, obtain the major permits, or produce test energy. If the developer falls behind, the customer may want to walk away from the deal and find another provider. Target dates for commercial operation might be backed with “delay” damages – payments owed for each day beyond the deadline.
At the same time, the CHP provider may negotiate for a liquidated payment in the event that the contract is terminated early. At a minimum, the provider would need to cover the financing costs of the CHP system and will seek the balance of its expected profits under the contract. It’s a reasonable position given the capital invested, but should be balanced against the value of the system and the ability of the provider to find a replacement customer.
Payment and Credit Risks
The need for credit assurance goes both ways. This is particularly true when dealing with start-ups and companies that do not have an established credit rating. Financing the construction of a CHP system is expensive and the developer’s lender will need to see that the payments under the long-term service contract are secured by more than just the CHP system assets. Payment and performance security are common and can take the form of posting cash, a letter of credit, or even a guaranty from a parent company. Providers also may want to impose a lien on the customer’s other assets as additional security.
The CHP development process requires careful navigation of the issues so that risks can be properly identified and allocated in a way that makes sense to both parties. Under ideal circumstances, the customer will have thoroughly assessed its needs well in advance of seeking bids from CHP providers. Armed with this knowledge and an understanding of common contracting pitfalls, customers can conduct a careful comparison of risk-adjusted pricing between the current energy arrangement and the proposed CHP system and help ensure the project is appropriately tailored and efficiently executed to meet their needs.
Joshua Belcher, counsel in Eversheds Sutherland (US) LLP’s Houston office, has a national, multidisciplinary practice counseling clients in the utility, power and pipelines sectors, with extensive experience in both the development and acquisition of utility-scale and customer-sited energy projects, including combined heat and power, wind, biomass and solar facilities. He can be reached at joshuabelcher@eversheds-sutherland.com.
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