Performance guarantees and performance liquidated damages (PLDs) are an essential element of most engineering, procurement, and construction (EPC) contracts, especially those related to solar and biogas projects; they make guaranteed levels of project performance, quality, and output enforceable. Specifically, PLDs compensate project owners for financial losses (or a reasonable approximation of them) incurred when projects fail to meet performance guarantees. Appropriately structuring PLDs in EPC contracts requires protecting project owners while balancing the risks for contractors, whose costs will often increase commensurate with increased contract risk. Ultimately, well-structured PLDs protect project owners, allocate appropriate risk to EPC contractors, and reassure financing parties that projects will perform as anticipated.
The Role of Performance Guarantees in EPC Contracts
Performance guarantees establish baseline capacity, output, or efficiency expectations for completed renewable energy facilities and assure project owners and their stakeholders, including financiers and offtakers, that the projects will operate as intended (such that financing obligations can be paid and offtake volumes generated). For solar projects, this often means meeting energy output metrics tied to the project’s Power Purchase Agreement (PPA). Similarly, for biogas projects, performance guarantees often focus on biogas quality, production volume, or other operational metrics tied to requirements of an offtake agreement or for obtaining and qualifying for certain renewable energy tax credits. The PPA and offtake agreement are each essential project components; they drive project revenue and are often essential to underwriting any project financing. A project’s failure to deliver (i) the required amount of power, or (ii) the required amount or quality of biogas will often trigger penalties in PPAs and offtake agreements, and may also put anticipated tax credits at risk. PLDs exist within EPC contracts to help compensate project owners for those losses.
Minimum Performance Guarantees: Liquidated Damages Calculations
Most EPC contracts include a minimum performance guarantee, which represents the absolute lowest acceptable level of project performance. The minimum performance guarantee is the baseline against which project performance is measured in determining the amount of PLDs. For example, a solar project developer may require its EPC contractor to achieve a guarantee of 98% of a project’s nameplate capacity. PLDs are often a fixed dollar amount per each percentage point (or fraction thereof) at which the project operates less than the capacity guarantee. For example, in the case of PLDs equal to $10,000 per every 0.1% capacity deficiency and a 98% capacity guarantee, a project that achieves 96.8% capacity would subject the applicable contractor to PLDs of $120,000.
Minimum Performance Guarantees: A Non-Negotiable Obligation
Unlike target performance guarantees, which might allow flexibility, a minimum guarantee is often a hard obligation. For that reason, contractors must ensure that their designs and construction plans are robust enough to meet this threshold. For example, solar and biogas projects often include an absolute obligation to achieve a minimum performance guarantee (including because, in the case of biogas projects, investment tax credits can depend on the quality of the project’s output), such that contractors are required to achieve a minimum guaranteed production. For example, there may be a guaranty of 98% of a project’s nameplate capacity yet a minimum guarantee of 93% of a project’s nameplate capacity. If a contractor fails to achieve the minimum percentage in that situation, it risks responsibility for all costs to achieve the minimum percentage, which could include the costs of a replacement contractor. It’s important for project owners to evaluate and align contractor guarantees with a project’s financial model and other relevant project contracts, including financing agreements, to avoid a gap in liability that might fall to the owner.
Timing of Performance Testing and Achieving Guarantees
The timing of performance testing is also critical in determining whether a project meets its guarantees. Typically, performance guarantees must be achieved by the substantial completion milestone; however, certain project considerations may allow flexibility. Some contracts may allow for additional rework or corrective measures if initial tests fall short. For example, a solar project may require achievement of a minimum guaranteed capacity by substantial completion but still allow the contractor to achieve the guaranteed capacity by final completion to attempt to minimize any PLDs. Owners and contractors should carefully negotiate the timeline for achieving performance guarantees, as well as the process for rework and retesting, to avoid disputes and align the obligations with the potential consequences in financing and offtake agreements. They need to also consider the length of the performance retesting and the financial consequences of failing to meet the guarantee by the applicable time. There may not even be an opportunity to reperform (including in the case of tax credits requiring that projects be placed in service by a date certain).
Performance Testing Considerations
The parties should set forth any specific testing requirements and procedures within an exhibit to their EPC contract. A solar EPC will typically set forth when the test must begin, how long it will last, the testing protocol and standards, and parameters around the reporting conditions. Biogas performance testing will be more specific, given the various inputs needed to conduct a test. For example, biogas project performance testing may require specifically setting parameters for total solids, volatile solids, ammonia, chloride, acidity and basicity levels, temperature, and scheduling for type and quality of feedstock. All those parameters are project-specific, such that any deviations can greatly impact project performance. Project owners need to understand testing parameters because some of them may be owner requirements (and owner’s failure to perform will excuse the contractor’s performance). Finally, the testing may be used to back into performance guarantees in the context of biogas projects: a 30-day test at 98% uptime may be used to calculate the average biogas yields, which may then be used to determine the guaranteed level of biogas production for the performance guarantee.
Considerations for Contractors to Minimize Risk
One of a contractor’s primary project concerns will be exposure to PLDs for failure to achieve a performance guarantee. Contractors should attempt to cap that risk at a certain percentage of the contract price, which may range from 5% to 25%; most projects include a 10% to 15% cap on PLDs (calculated based on the EPC contract price). But, contractors should understand that PLDs caps will often not absolve them from liability if they fail to reach a minimum performance guarantee; rather, failures to meet minimum performance guarantees often trigger reperformance obligations, not PLDs, and those reperformance costs are often subject instead to a larger overall limitation of liability.
Contractor should also consider how the failure to achieve a performance guarantee can cause delay liquidated damages (DLDs), in addition to PLDs. Often, achieving at least the minimum performance guarantee is a condition to substantial completion. The failure to timely achieve substantial completion will trigger DLDs, potentially exposing contractors to double liability. Contractors should thus consider the time required for both initial testing and any re-testing or re-performance in negotiating project completion deadlines. If contractors are not permitted the ability to reperform and correct any tests after substantial completion, they should factor those considerations into the contract’s risk profile via its pricing and scheduling.
Alternative Considerations
There is not a “one size fits all” approach to PLDs. The optimal structure depends on the unique characteristics of each project, the financial model, and the allocation of project risks. Below are several alternative considerations when aligning PLDs and performance guarantees with project realities.
For project owners who anticipate selling electricity into the wholesale market before the Power Purchase Agreement (PPA) obligations begin, it may be appropriate to design PLDs to reflect the difference between actual and expected merchant revenue during the period between mechanical completion and substantial completion. If merchant revenue forms a material part of the financial model, the PLD mechanism could specifically compensate the owner for any shortfall in expected revenue during this interim period.
Alternatively, instead of relying solely on a single performance guarantee at substantial completion, owners may require an initial capacity or performance guarantee at mechanical completion or prior to a project being placed in service. This staged approach can help ensure that the facility is able to generate and sell electricity earlier, and it can provide a basis for interim compensation if the project underperforms before reaching substantial completion. Such guarantees can still be coupled with traditional PLDs at substantial completion and offer more protection against lost revenues for underperformance at an earlier stage.
Although less common, sometimes parties may agree to alternative compensation mechanisms. For example, an owner may share a portion of merchant revenue during the interim period, or provide “early generation” payments at a pre-agreed rate for electricity generated and delivered prior to the PPA start date, as an incentive to the contractor. Also, and still less common than using PLDs, an owner could seek to mitigate risk by using certain insurance products designed to cover loss of revenue or increased costs. These mechanisms can help bridge the gap between project completion milestones and contractual revenue streams.
Finally, for biogas projects, careful attention should be paid to which party is best positioned to provide performance guarantees and PLDs. If a specialized equipment supplier is responsible for a critical component (such as biogas upgrading equipment), it may be most appropriate for that equipment supplier to provide the relevant guarantees. Where the EPC contractor procures such equipment, coordination is needed to ensure guarantees and PLDs flow through the EPC contract. Alternatively, if the owner procures key equipment directly, it should negotiate guarantees and PLDs directly with the supplier. In all cases, clear alignment among all parties on the scope, triggers, and remedies for performance shortfalls is essential to avoid gaps in protection.
Conclusion
Performance guarantees and PLDs are a cornerstone of renewable energy EPC contracts, providing a mechanism to address financial losses resulting from poor project performance. For solar and biogas projects, PLDs are often tied to revenue losses, ensuring a fair and proportional remedy for project owners while allowing contractors to calculate expected risk for its performance failures. By carefully structuring performance guarantees, liability caps, and termination provisions, owners and contractors can create a balanced contract that protects both parties’ interests. Understanding the nuances of performance guarantees and PLDs are essential to navigating the complexities of renewable energy EPC contracts.
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