Calculating Termination Payments and Purchase Prices

In a previous article, we discussed the differences between a sovereign guarantee and a put and call option agreement (PCOA). This article examines a few methodologies that can be used to calculate the purchase prices that become payable upon the exercise of a put option or call option under a PCOA, or the termination payments that become payable upon the termination of a power purchase agreement, concession, or other project contracts.

Background

In virtually all countries in Sub-Saharan Africa, there is only one purchaser of electricity from utility-scale power projects. If the power purchase agreement is terminated, the project company may no longer be able to sell capacity or energy and may no longer generate reliable revenues. The same is generally true for public infrastructure projects outside the power sector.

As a result, sponsors and lenders typically require an offtaker, contracting authority, or host government to agree to purchase the project, or the shares in the project company, at an agreed price in the event the power purchase agreement, concession agreement, or other project contract is terminated. If this obligation is contained in the power purchase agreement or concession agreement, the compensation payable to the project company (or sponsors) is generally referred to as a termination payment or as termination compensation and is usually guaranteed by the host government (or is a direct contractual obligation of the host government). If this obligation is contained in a PCOA, the compensation payable to the project company (or sponsors) is generally referred to as the purchase price or the exercise price.

Regardless of whether the termination compensation is stated as a termination payment or a purchase price, the events that trigger a termination of the power purchase agreement or concession and lead to an obligation to purchase (or sell) the project should be carefully considered. Potential trigger events include a termination by either party following:

• an event of default by the project company;
• an event of default by the offtaker or contracting authority;
• an event of default by the host government under a government support agreement or implementation agreement;
• a prolonged natural force majeure event;
• a prolonged political force majeure event;
• the expropriation of a material part of the assets of the project company or of shares in the project company; and
• depending on the technology, the prolonged unavailability of fuel for a generation project.

Calculating termination compensation

For both termination payments and purchase prices, the methodology that will be used to determine the amount of compensation should be agreed at the outset of the project and clearly described in the PCOA, power purchase agreement, or concession agreement. Although the core elements of the methodology usually remain the same, the amount of the compensation may differ – sometimes significantly – depending on which party terminates the power purchase agreement or concession agreement and the event that led to the termination.

For independent power projects and other projects in which substantially all of the capital expenditure takes place at the beginning of the project, the purchase price or termination payment may be calculated using a methodology that is similar to the methodology describe below.

Project company events of default

If the project is terminated following an event of default by the project company, the purchase price or termination payment might equal:

(i)  all debt outstanding (including outstanding principal, outstanding interest, prepayment fees, hedge break costs, and other charges); plus

(ii)  all termination costs incurred by the project company (costs incurred by the project company in connection with the termination of the project, including taxes, amounts payable by the project company to the EPC contractor under the EPC contract, and amounts paid to terminate other significant project agreements; less

(iii)  the account balances (all funds that are under the control of the lenders and are available to be applied by the lenders to reduce debt outstanding, including all funds on deposit in any debt service reserve accounts or collateral accounts); less

(iv) insurance proceeds.

Offtaker events of default

If the project is terminated following an event of default by the offtaker or other contracting authority, the purchase price or termination payment might equal:

(i) debt outstanding (as described above); plus

(ii) termination costs (as described above); less

(iii) the account balances (as described above); less

(iv) insurance proceeds; plus

(v)  the amount of equity contributed by the sponsors; plus

(vi) a return on the equity contributions of the sponsors calculated with respect to each contribution of equity for the period from such contribution until the date on which the project is purchased using the projected internal rate of return on equity from the financial model; less

(vii)  all distributions of capital from the project company to the sponsors, including distributions in the form of dividends, payments of interest or principal in respect of shareholders’ loans, or returns of capital.

Other termination events

If the project is terminated following a prolonged natural force majeure event, a prolonged political force majeure event, the prolonged unavailability of fuel, or an expropriation of the assets of the project company or the shares issued by the project company, then the purchase price or termination payment may include some elements of the purchase price that would be payable following an offtaker event of default, but may or may not include all of those elements, and should be negotiated based on the specific circumstances of each project.

Other considerations

It is possible to state the return on equity using various alternative formulations. For example, the return on equity might equal the equity contributed times the projected internal rate of return times a number of years. The return on equity could also be described as the net present value of the expected distributions to the sponsors over the remaining term of the project agreements, discounted at an agreed rate of return (which would typically equal the project internal rate of return on the equity invested in the project). These different descriptions may lead to very different outcomes, so it is important to model all of these formulations under various scenarios to ensure that the consequences of these different formulations are well understood.

Consideration should be given to adjusting the expected returns on equity if the project is not performing as anticipated for reasons that are not attributable to the offtaker, the host government, or authorities of the host government. Developing mechanisms that fairly address poorly performing projects can be challenging, but the alternative – failing to address the issue – can lead to circumstances in which a party may have a financial incentive to declare an event of default and terminate the project. Perverse incentives such as this one should be avoided whenever possible.

For projects that require significant capital expenditure throughout the life of the project, other methodologies should be developed that properly address the additional capital expenditure incurred and account for the depreciation recognized and recovered under the methodology used to establish the tariff or user fees. These methodologies are usually closely tied to the tariff methodology and the depreciation that is recognized and permitted by that methodology.

Finally, in all cases appropriate legal due diligence should be undertaken at the outset to ensure that the methodology for determining the amount of any purchase price or termination payment is consistent with the legal framework that governs the project or the sector more generally.