By Peter V.K. Funk, Jr.
Presented at World Energy Engineering Congress
October 18, 2018
Published January 24, 2019
This article provides an overview of legal, contractual and other considerations involved when a hospital retains a third-party provider (“Provider”) to procure, install, own and operate a CHP and boiler system on the premises of a hospital in connection with a natural gas pipeline for the purpose of selling electric power and thermal energy to the hospital. It will discuss the contractual relationship between the hospital and the Provider and issues related to entering into a power purchase agreement (PPA) or energy services agreement (ESA) together with discussing utility, regulatory, financing, energy pricing and other considerations. It also addresses the respective objectives and risks of the Provider and the hospital.
The process of installing new energy systems in hospitals poses special challenges. The electrical and thermal energy systems in these hospitals are truly mission critical, with the potential for catastrophe should power fail. While heat, hot water, and electricity are important everywhere, in hospitals a loss of energy can literally be a matter of life and death. For that reason, even with CHP systems, hospitals may, depending upon the applicable regulations, may still require a back-up generator. Further, like other major construction projects, the installation of a cogeneration system in a hospital first requires governmental approval. But the good news is that, because CHP systems are aimed at conserving energy, plans to install one are not as likely to be mired in paperwork. In New York State, for instance, energy conservation projects that cost less than a certain amount are exempted from full review—a process that typically takes nine months to one year. Instead, in those cases, the state only undertakes a limited prior review, which often can be accomplished in a matter of weeks.
In addition to complying with specific statutory requirements, hospitals also will typically need to make sure that they have a plan that will ensure patients’ or residents’ safety while keeping disruption to a minimum.
Older hospitals with outdated boilers and energy systems near or at the end of their life cycles can be good candidates for a CHP and supplemental boiler system which replaces or supplements their existing thermal energy production. The availability of long-term, favorably priced gas as fuel to reduce the cost of electrical power and thermal energy and the availability of financial incentives can provide a powerful motivation to implement such a system.
Older hospitals, however, often have complex financial, construction, equipment, procurement and management histories which may make contracting with an outside Provider preferable to doing the project in-house. In order to implement a successful CHP system, the Provider and the hospital must identify potential issues such as regulatory, financial, utility, tax, real property, contractual and other legal difficulties. These difficulties can usually be resolved, particularly if identified and addressed early on. Experienced engineering, legal and accounting professionals should be engaged from the onset to perform due diligence, identify such issues and develop a plan to resolve these issues.
Advantages. An effective CHP system, whether operated in-house or by a third party selling to the hospital, will reduce the cost of operations and improve cash flow. It is also a form of financing since the hospital will not be incurring the capital costs for procurement and installation. However, as discussed below, accounting considerations require that the transaction be structured properly to avoid inclusion of the capital cost on the hospital’s balance sheet. As a general matter, CHP can provide a cost-effective solution to facility operating issues confronting the hospital. A properly designed, high efficiency CHP system with favorable fuel costs delivers multiple benefits such as reduction of the cost of hospital expenses by significantly reducing energy costs. This improved cash flow, particularly when structured to include third party ownership, operation and sales, makes financial resources available for other purposes, such as acquiring medical equipment. CHP systems also improve power (and thermal energy) reliability and resiliency above that offered by the utility grid.
CHP Efficiency. CHP systems are especially practical as they produce electric energy 24/7 and are most efficient when placed in steady-use environments like hospitals. Hospitals typically have a 24/7 demand for thermal energy to provide heat and hot water for facilities such as hospital rooms, offices, kitchens, laundries and common areas. Since the sizing of the CHP units are directly related to the ability of the host facility to utilize thermal energy produced by the CHP system, hospitals, with a significant thermal energy demand, are good candidates for installation of CHP systems. The major conservation benefit of CHP systems is that they conserve energy by recovering thermal energy produced by the generation of electricity, and then use the thermal energy to make hot water and heating and cooling for the facility and produce substantial savings. Since a well-designed CHP system’s production of both electrical and thermal energy can achieve efficiencies above 85%, it far surpasses the efficiencies that can be achieved by utility power plants which is diminished by the cost.
Cost-Effective Fuel Supply. A cost-effective fuel supply is critical to producing cost savings. The increasing availability of gas from fracking and other sources, such as bio-gas from cow manure digesters, has supplemented the supplies available from traditional sources of natural gas has resulted in far lower gas prices in this era than were projected a few years ago. In addition, utilities may offer special rates for on-site cogeneration gas. In the type of transaction structure under consideration in this article, the Provider typically seeks to procure the longest term, low-cost gas supply as is available in the market from a shale gas source. Before a Provider will commit to a long-term arrangement, however, it will need exclusivity and a long-term PPA or ESA with the hospital.
Off-Balance Sheet Capital Costs. In situations where CHP is appropriate for a hospital, the cost of CHP system electric and thermal energy output procured from a Provider relative to its benefits can be reasonably low and produce attractive returns. The capital costs are borne by the Provider and off-balance sheet to the hospital which can provide real benefits since an older hospital is likely to have a complex financial history that can make borrowing complicated at best and unduly difficult or expensive at the worst. Hospitals typically have “bricks and mortar” facilities and medical equipment capital costs that take priority and a third-party Provider arrangement preserves such priorities.
Incentives. CHP systems are often eligible for subsidies or tax breaks from federal, state, and local governments. In New York, for example, which has among the largest number of hospital facilities in the country, the New York State Energy Research and Development Authority (NYSERDA) offers monetary incentives for on-site generation, which from time to time have included breaks in the interest rate on loans. Moreover, a major portion of the cost of installing the CHP systems may be reimbursed through Medicaid. Sometimes, hospitals are also able to use the CHP system or the additional backup generator to make money by selling power, or “curtailment,” in the wholesale market. Any Provider considering a CHP project at a hospital must determine whether federal, state and local or utility incentives programs are available to reduce capital costs and the agreement structure must reflect provisions to realize those benefits. In some instances, the owner rather than the contractor may be eligible to receive incentives which requires appropriate contractual provisions in the PPA or other agreements. These various incentives can produce substantial reductions in capital cost (25% or even substantially more). For example, to illustrate percentage, a current NYSERDA incentive is providing an incentive totaling $791,280 in connection with a $1,375,000 CHP project. Such incentives substantially reduce the amortization period for borrowed funding and thereby reduce the payback period.
Timing Issues. Installing a new CHP system to coordinate with new construction and to replace aging (or even failing) boiler equipment adds time pressure. It may be that satisfying all of the regulatory, utility and other standards takes longer than the time-frame in which the power supply for the new building is needed requiring expensive duplicative equipment or raises the possibility that a boiler may fail during the heating season requiring expensive and perhaps unavailable temporary heating. For that reason, the timing must the realistically and carefully projected.
- Accounting considerations – Financial Accounting Standards Board (FASB) ASC 842 Lease Accounting. The FASB recently updated an older accounting standard to provide, among other things, that a PPA or an energy services agreement ESA under which electric power and thermal energy is supplied may constitute a capital lease if its terms are analogous to a lease (i.e., terms such as providing a fixed stream of payments). To comply with the requirements of ASC 842, electricity and thermal energy must be metered and the hospital must pay the Provider based upon usage.
- Exclusivity and Operational Covenants. The hospital must covenant to take the entire output of the CHP system and, therefore, the system must be carefully sized with respect to the demand curves of the hospital. In the event that, for some reason, the hospital cannot take the entire electrical output, the Provider must be able to sell to the grid, which will require an interconnection as discussed below. In the event that the price of electric power that the Provider is paid from such outside sales is less than the price that the hospital pays under the PPA, the parties must bargain as to whether the hospital must make up the difference. Of course, that sword cuts both ways – the parties will have to negotiate a provision addressing the situation in which the Provider has an unscheduled outage and the hospital pays more for electricity per kWh (or pays additional standby charges to the utility) than the price it pays to the Provider. Under the Uniform Commercial Code (UCC 2-712), this is termed a “cover” situation.
Ideally, a financier would want a “hell or high water” guarantee of a revenue stream, but that is incompatible with revenues based upon metering which, of course, can vary. Therefore, any covenants relating to levels of promised demand given by the hospital to the Provider (i.e., the hospital will consume ___ kWh of electricity per year) must be given careful consideration in light of ASC 842. In my experience, in all cases, Providers should conduct careful due diligence and not only look into prior and projected energy usage by the hospital but into its future needs as a medical facility, including the circumstances of other hospitals in the vicinity, surrounding demographics, hospital finances and other factors that impact upon the future of the hospital.
Leasing and security interests. The entity financing the CHP system is likely to desire that the CHP system be sited on a parcel leased by the hospital to the Provider and that the lease be recorded. The Provider would then have legal access to the CHP system as would its financier – in the event of a default. The financier would also seek a security interest in the CHP system, but such interests can be complicated by the interests of prior financiers in the underlying real property owned by the hospital. Further, the Provider’s financiers may require a waiver from such prior financier(s) of the hospital which can be difficult to obtain.
Tax issues. A careful analysis of potential tax issues, including real property tax issues, must be performed but such an analysis is beyond the scope of this article.
- Standby Rates. Since the sizing of the CHP system is typically based upon the thermal load of the hospital, the electric output of the CHP system will, at times, likely be insufficient to supply the requirements of the hospital and, to that extent, the hospital must take standby service from its distribution utility. The hospital should perform a realistic financial analysis of the impact of its potential usage under the standby rate (including scheduled and possible unscheduled outages), which will be more expensive than taking power as a full-service customer or, if permitted in the state, contracting to purchase electric commodity from an energy services company for delivery by the utility.
- Interconnection. A traditional CHP installation involves synchronous generation with the utility. It will be necessary to interconnect with the local utility for the purpose of receiving electrical power from the local electric utility and selling to the grid in the event that the hospital cannot take the entire output of the CHP system. This will require an interconnection agreement with the local utility. Careful attention must be paid to the requirements of the utility tariff and the regulations of the state public service/utility commission and, if applicable, the requirements of the state independent system operator (ISO). It is best to leave a conservative amount of time to complete the interconnection approval and installation process since interconnection with the distribution grid to enable sale of utility electric power, back-up and/or selling excess electric energy to the utility can require time-consuming interconnection approvals. It may also be necessary for the hospital to pay for new or costly upgrading of utility distribution lines or transmission lines above certain voltage levels. In addition, independent system operators (ISOs) may impose requirements.
Metering and Energy Pricing. It is critical from the perspective of the hospital that the electric commodity and capacity and thermal energy be metered. Conceptually, the hospital is providing an exclusive “service territory” to the Provider and the best possible incentive for the Provider to achieve the highest possible availably of service is to only pay for services provided. Following is an example of a list describing metering provisions for a particular type of to be included in a PPA which is based upon a “utility” ratemaking model:
- Payments based upon Metered Service: Electricity and thermal energy provided to the hospital will be metered and billed to the hospital based solely upon metered usage. There will be no fixed payment streams. The rates will be based upon a modified utility rate case model for the plant and facilities to be installed, operated and maintained by, or on behalf of, Provider as follows:
- Rate components: The components upon which these rates will be based include:
- Provider’s total CAPEX for plant constructed and installed to provide service to the hospital - less accrued depreciation;
- Provider’s guarantee of an agreed-upon cap on the total CAPEX to be used for metered billing purposes. This CAPEX used for rate-making purposes would be all-inclusive and include the costs to design, engineer, procure and construct and install all elements of the plant;
- O&M expenses;
- Other direct expenses such as insurance;
- Cost of fuel and delivery;
- Charges for the use of the back-up generators, which will be based upon their capital cost, the cost of O&M and fuel; and
- Sales taxes – if applicable.
- Other metering considerations:
- Rate design will allocate cost between electric commodity (kWh), capacity (kW) and thermal energy (lbs. of steam). Chilled water will not be subject to metered charges since it is a sub-product of steam;
- Provider shall have the exclusive right to provide electric power and steam to the hospital except to the extent that Provider is unable to meet the hospital’s demand for electric power or steam (including chilled water);
- the hospital is to approve all meters to be used by Provider; and
- Provider will provide remote meter reading and provide a portal to the hospital so that the hospital can monitor usage and other information.
- Other types of pricing provisions.
- Reference Price for Electric Commodity. The Unit Price per kWh to be used by the Provider to determine the price with respect to each month following the Commencement Date shall be ___ percent less than the price per kWh charged to the hospital by the Utility during that month under Account: _______.
- Escalated Fixed Cost. The Unit Price per kWh to be used by the Provider shall be _____ per kWh. It shall be escalated at ____ percent (or the applicable CPI) following each 12 month period month from the commencement of service by the CHP system.
- Third party metering. A point to consider in connection with metering is whether an independent third-party metering entity should install and perform the metering.
Energy metering and pricing provisions should be written carefully, and attention should be paid by each party to the pricing calculation and how it is determined. A poorly written pricing provision can result in needless misunderstandings and disputes.
Contracting for consulting and engineering services. It is key for a hospital to have engineering and/or other technical consultants experienced in dealing with Providers and CHP advising as to the installation and operation of the CHP system by a third-party Provider. On-site CHP systems involve PPAs or ESAs and other complex contracts. Without solid experience and understanding of the process, it is very difficult for most hospitals – other than those with highly experienced in-house capabilities – to fully participate in an CHP project in a cost-effective manner.
Regulatory considerations. It is necessary to check state Commission requirements for Providers and the proposed CHP system as approvals may have to be sought and obtained. Failure to do initially may result in finding out too late.
Installation and Operations. CHP systems require a suitable space, and an engineering determination is necessary for siting. Many hospitals will permit Providers to install such systems in basement boiler rooms, but they can also be placed on rooftops, setbacks, or even in generator sheds located adjacent to or near the hospital buildings. In operation, CHP systems are not loud but do make noise, and are often placed inside insulated cabinets. Some hospitals have dealt with the noise by constructing interior rooms out of cinderblock within boiler rooms, specifically to house the cogeneration system.
Limited Liability. A Provider should recognize that manufacturers of CHP equipment and utilities may have limited liabilities (gross negligence or $ limitation) or no liability for any damages that result from a power outage, and hospitals should seek expert consultation on protective steps to take.
Existing Contracts. The Provider and the hospital must take care to make sure that all existing ESCO supply contracts and energy management agreements are identified and resolved as necessary in connection with implementing a CHP system installed and operated by a Provider.
Planning Process. It is not an easy or short process for a hospital to go from A to Z in implementing such projects and the contracting process for a PPA or ESA with a Provider can be complex. Such energy projects for hospitals are often large and involve many steps and processes beginning with requesting and analyzing proposals and continuing with contract preparation and negotiations in connection with PPAs and other related agreements. These steps also include securing regulatory and utility approvals and any other incentives that may be available, and arranging for financing and the administration, implementation and operation of the project. A hospital must also comply with complex state regulations together with any applicable federal and local laws. It is also reasonable to anticipate that regulatory approval for project may take months. When applicable, keeping the board of the hospital informed and involved is also important since the project cannot proceed without board approvals and the complexity of such projects and the related financings can require time in order to familiarize the board with the on-going status of the projects. As mentioned above, specialized consulting and professional services are necessary to provide guidance.
Another factor which must be considered is the need to take into account the necessity of replacing critical equipment before failure or compromise. For example, in one project, the primary boilers required replacement or had to be supplemented with a CHP system prior to the next heating season. Planning must take into account potentially long lead times for ordering the CHP units and any supplemental boilers or thermal storage tanks to ensure that these are installed in sufficient time.
Emergency Considerations. The PPA must recognize that loss of power at hospital facilities pose a significant threat of loss of life or harm to patients, and the greater reliability of an on-site generating system – which supplements and is supplemented by grid power – provides safety. That safety is key to maintain critical elements at hospitals, which include operating rooms, intensive care units, and life support equipment – although many other functions such as lighting, heating, cooling, communications, and elevators are also essential. State regulators recognize the importance of uninterrupted power to hospitals and other healthcare facilities by requiring them to have on-site back-up power. For example, the New York State Department of Health requires each hospital to have an established plan of emergency electric service in the event of an electrical system failure. Hospitals typically satisfy these requirements by having onsite back-up generation interconnected to the utility grid or separated from the utility grid by a transfer switch that will switch to and activate on-site power upon any loss of utility power.
In the event of an emergency, to what extent can a Provider or a hospital rely upon agreements with manufacturers and maintenance providers? Manufacturers’ or installers’ warranties for installed back-up generators or synchronous cogeneration units may be for as little as one year and might only require the provider to supply equipment, parts and labor to restore the generator to working order. In fact, sales agreements often include a provision limiting the liability of the manufacturer. A maintenance provider will have emergency response obligations, but these would not include mandatory operation of a generator (or key portions of the generation system or its fuel supply) that is, for example, under flood waters.
Contracting with a CHP system provider can provide numerous benefits to hospitals that they might not be able otherwise accomplish. These arrangements rely heavily upon complex contractual commitments by the Provider agreements to the hospital in PPAs or ESAs and related documents which must be carefully drafted and effectively negotiated.
Note: This article is of a general nature and not intended to be legal advice. Readers should consult an attorney for legal advice.
Peter Funk is a partner at Funk & Zeifer LLP where he practices in the area of energy law with a focus on energy generation and energy management/conservation projects. Funk's column Legal Perspectives discusses legal issues pertaining to energy generation and conservation.