Current COVID-19 Topics
in the Power Industry
By: Alex Smorczewski, Amy Maloney and Casey August
Morgan, Lewis & Bockius LLP
During this unprecedented time of global pandemic, the power industry has found itself under extraordinary pressures and been forced to confront many issues of first impression. Following is a brief treatment of several topics that have come to the fore in the power industry in the midst of the COVID-19 crisis.
Operating Projects and Projects under Construction
The U.S. Federal government provides guidance on which sectors of the economy are deemed “critical infrastructure” via the Cybersecurity & Infrastructure Security Agency (CISA) within the U.S. Department of Homeland Security, although the enactment of policy regarding which types of workers are deemed essential takes place largely at the state level. This guidance was initially released on March 18, 2020 and is subject to ongoing revision and update. CISA has identified the energy sector as one of 16 critical sectors, and consequently the states have generally permitted the operation and maintenance of energy projects to continue and, with certain exceptions, have also allowed the continuing construction of energy projects. State-specific resources should be consulted in all instances given that the states are not taking a uniform approach. Many law firms, including Morgan, Lewis & Bockius LLP, have developed COVID-19 umbrella task forces (with targeted sub-task forces within) to assist their clients in analyzing the effects of the pandemic on industries and business operations at both a federal level and a state level.
In addition, many energy projects, particularly those under construction, have suffered the effects of supply chain disruptions resulting from shortages and delays in materials and equipment supply and reduced availability of workforce. Consequent declarations of force majeure by contractors under construction contracts have been widespread, and those declarations have, in turn, resulted in substantial strain on project construction schedules and budgets, which, in turn, could ultimately give rise to draconian repercussions under financing arrangements and hedging and offtake contracts for failing to achieve project completion by specified deadlines. These repercussions are exacerbated for projects that intend to obtain federal incentives that impose construction requirements and completion deadlines as conditions to qualification, as discussed further below (and noting that there was some very recent reassuring news for these projects, also as discussed below). As these schedule and budget related risks have heightened in the current environment, investors in projects that have ongoing construction draws have intensified their scrutiny of construction draw requests and exerted pressure on sponsors and developers as well as independent engineers, lawyers and other consultants to demonstrate feasibility of project completion on revised projected timelines and the reasonableness of the underlying assumptions regarding projected supply.
Uncertainty surrounding the sustainability of supply chains and workforce has unsurprisingly suppressed the financing markets’ appetite to finance new construction projects, and rising costs of capital from financing sources are compounding the challenges that sponsors face in maintaining the economic viability of their projects in development.
Many developers of projects seeking to obtain subsidy through the federal Investment Tax Credit or Production Tax Credit have been racing to complete projects that “started construction” in 2016 or 2017 within the ensuing four-year “continuity safe harbor” window expiring at the end of 2020 and 2021, respectively. Outside of such window, depending on whether construction was started under the “5% cost safe harbor” or “physical work of a significant nature” test, a developer must demonstrate under the applicable facts and circumstances either continuous efforts to advance towards completion or a continuous program of construction, respectively. Thus, while it is technically possible for a project to qualify outside of the four-year safe harbor, owing to an absence of definitive IRS guidance on the subject, tax equity investors have historically been hesitant to fund projects that cannot fit within the four-year safe harbor window.
In order to provide certain relief from the foregoing pressures faced by many projects currently in development, on May 27, 2020, the IRS released Notice 2020-41, which extends the continuity safe harbor for projects that “started construction” in 2016 or 2017 utilizing the 5% cost safe harbor or physical work test from four years to five years.
In addition, Notice 2020-41 provides a permissive safe harbor for applying the “3½ month rule” for projects “starting construction” under the 5% cost safe harbor. The 5% cost safe harbor requires that 5% or more of the cost of qualifying project property be incurred by the end of a year. A developer contracting for equipment or services can establish having incurred the expense for this purpose at the time of initial contracting and payment so long as delivery or performance is reasonably expected within 3½ months of payment, notwithstanding that performance or delivery actually occurs in a subsequent year. Notice 2020-41 provides a safe harbor that contracted-for work or equipment paid for on or after September 16, 2019 and received by October 15, 2020 will be deemed to have satisfied this “3½ month rule.” Services or property not satisfying the requirements of this safe harbor are not necessarily precluded from the 3½ month rule, and may still qualify based on facts and circumstances.
As we progress deeper into 2020, much of the long-term impacts of current conditions on the power industry will depend upon whether the present economic contraction is V-shaped or the tipping point for a prolonged global recession or depression. While forecasts vary, most expect the pandemic and ensuing recession to deal the most serious blow to demand for energy that the global economy has seen in decades. On May 5, 2020, the International Energy Agency (IEA) released a forecasted scenario in which global energy demand in 2020 contracts by 6%, the largest in 70 years in percentage terms (and more than 7 times larger than the global contraction in the 2008 financial crisis) and the largest ever in absolute terms. Significant declines are forecast in demand for oil, coal, gas and nuclear power. This reduced demand is expected to slow the pipeline of new projects being successfully brought to financial close.
One bright spot in the IEA forecast is renewable power, which to date has demonstrated some resilience with recent announcements of financial closing for several large-scale renewable energy projects. That said, industry observers remain split on whether this is more a reflection of the strong pipeline headed into the crisis or a harbinger that the renewables sector will remain impervious to social and economic degradation as the pandemic persists.
Larger, better capitalized and experienced developers are expected to fare better and rely on long established relationships with lenders and other sources of capital, whereas smaller developers may struggle and proactively seek out strategic combinations and asset divestitures. While many large tax equity providers have publicly reiterated their commitment to continue to provide tax equity financing, a key source of capital for renewable projects, many fear that a souring economy and increasing write-offs and tax losses for traditional providers of tax equity financing will be a net negative for this source of capital going forward, forcing developers to seek alternative sources of funding. As a potential counterbalance to the exit, or reduced appetite, of some traditional tax equity players, we may in fact see that major corporates that fare well during these troubled times in spite of (or, in some cases, because of) current conditions further the recent trend of large corporates engaging in the tax equity financing market to offset their own capital gains.
We, like everyone, look forward to an eventual full and sustainable reopening of the economy and hope that market players greet such reopening with the investment enthusiasm that has accrued, restrained, over the past months.
For current resources and information on legal matters surrounding the COVID-19 crisis, we encourage you to visit to you the Morgan, Lewis & Bockius LLP task force homepage at: https://www.morganlewis.com/topics/coronavirus-covid-19