The University of Texas School of Laws 31 Annual Ernest E.

Smith Oil, Gas & Mineral Law Institute

st

April 1, 2005 Houston, Texas

WHERE ONE SIZE DOESNT FIT ALL: CONTRASTING THE METHANE GAS LEASE, WIND LEASE AND OIL AND GAS LEASE

Lisa Chavarria

Lisa Chavarria McElroy, Sullivan & Miller, L.L.P. Austin, Texas lchavarria@msmtx.com (512) 327-8111

WHERE ONE SIZE DOESNT FIT ALL: CONTRASTING THE METHANE GAS LEASE, WIND LEASE AND OIL AND GAS LEASE1 Lisa Chavarria I. INTRODUCTION

As oil and gas practitioners, most of us routinely interpret oil, gas and mineral leases. With the recent surge in the wind industry and the increase in the number of municipal solid waste facilities that generate and sell landfill gas more of us have been asked to draw upon our skills as oil and gas practitioners to draft or review wind and landfill gas leases. When called upon to undertake such a task, we each bring our very germane oil and gas experience to the table. This experience is beneficial; however, it can create a myopic view of a transaction which may undercut the practitioners ability to serve his clients best interests. Whereas these two industries are relatively new in Texas, there has been a tendency for practitioners to use oil and gas leases as a template for drafting wind and landfill gas leases. Although there are strong similarities among the industries, one lease form cannot serve each industry. While there are clauses from an oil and gas lease that may be easily modified for use in a landfill gas lease or a wind lease, there are specific problems presented by each industry that require special attention and their own, specially drafted clauses. The purpose of this paper is to discuss the essential elements of a wind lease and a landfill gas lease with an emphasis on the clauses in each that must be specifically tailored to that industry. In order to properly serve a client that seeks legal advice in any area, a working knowledge of how the industry works is essential. Many of the concepts presented in a wind lease or landfill gas lease are much easier to understand when one has an understanding of how a wind farm works or how a landfill gas collection system is set-up. Unlike in the oil and gas industry, the tax credits wind and landfill gas receive are critical to the growth of each and may even dictate the way a lease is structured. Consequently, a working knowledge of the applicable tax credits is necessary as is an understanding of some basics of how a wind farm and a landfill gas collection system are built.

II.

WIND POWER A. Overview and Relevant Tax Considerations.

Wind power took off in Texas in 1999 when the Texas legislature enacted the Renewables Portfolio Standard (RPS). The Texas RPS is a minimum content requirement that grows over time and allows the market to choose which renewable energy technologies are the most costeffective. Eligible technologies include wind, solar, geothermal, wave or tidal energy, biomass and methane gas from landfills, and hydropower. Of the renewable sources of energy eligible under the RPS, wind power is currently the least expensive.1 As of May 2004, wind power made
1

The author wishes to thank Greg Friend of McElroy, Sullivan & Miller, L.L.P. for his insight and input in the writing of this paper.

up approximately 88% of the renewable energy facilities in Texas.2 To add flexibility and reduce the cost of meeting the requirement, tradable renewable energy certificates (REC) are used to track and verify compliance. 3 A REC is a tradable instrument that represents all of the renewable attributes associated with one megawatt hour (MWh) of production from a certified renewable generator.4 Electricity retailers who serve competitive markets, utilities and cooperatives (Participants) are required to meet their portion of the renewable energy requirement by presenting RECs to the Public Utility Commission (PUC) on an annual basis.5 Participants can meet their REC requirements by generating the required portion of the electricity by renewable energy technology; by purchasing capacity using such technology; or by purchasing sufficient energy credits to satisfy its requirements.6 Failure of a Participant to meet its designated requirement results in an enforcement penalty. To help ensure compliance, the penalties for non-compliance exceed estimated compliance costs. The Production Tax Credit (PTC) is a key piece of federal legislation that plays an important role in the financing of new wind power installations and has helped expand the wind industry throughout the country. The PTC originated in the Energy Policy Act of 1992 and allows qualified owners of wind power projects to claim a tax credit on their corporate income tax returns.7 In 2001, the PTC was worth about 1.5 cents per kilowatt hour (this figure is periodically adjusted for inflation) of electricity generated by wind turbines and delivered to the grid.8 Experts estimate that wind power projects in Texas are able to deliver power to the grid for about 4.5 cents per kilowatt hour (KWh).9 Once the PTC, which is presently worth about 1.8 cents per KWh, is factored in the cost to deliver wind energy to the power grid is less than 3 cents per KWh. The PTC has been credited for rapid growth in the industry and is widely considered to be an essential part of the success of wind power.10 The PTC is presently scheduled to expire on December 31, 2005. Wind power installations in 2005 are predicted to surpass 2000 MW, which would be the largest single year jump in capacity installations on record.11 B. Negotiating a Wind Lease

Understanding how a wind project comes together and works is vital to comprehending the basic terms contained in a wind lease. Therefore, I will discuss the major clauses found in a wind lease in the context of the stage in the building of a wind farm at which they appear. An important preliminary issue for the practitioner to keep in mind when negotiating a wind lease is that, unlike oil and gas operations, every wind project requires that surface rights to hundreds or thousands of contiguous surface acres be secured. A practitioner will want to maximize his clients economic benefit and may be tempted to insist on each attractive lease clause discussed in this paper. It should be remembered, however, that the negotiating strength of a landowner is directly tied to the importance of his land to a project. For example, a large landowner would obviously be in a better position to negotiate additional items because he may hold a large section of property that is essential to a wind project. In contrast, a small landowner may negotiate himself out of a project if building around the small landowner is easier than negotiating with him. The difference in relative bargaining strength could also raise conflicts of interests for a practitioner who negotiates leases on behalf of both large and small landowners for inclusion in the same project. On one hand, having one knowledgeable person the wind company can deal directly with could benefit all the landowners and may result in a form of ad hoc

collective bargaining. On the other hand, a practitioner could inadvertently undercut the position of one landowner to improve that of another. To avoid any problems, a practitioner should disclose at the outset whether he represents other potential lessors. 1. The Option Period

The first step in the process of building a wind farm is securing an option from each landowner within the prospective wind farm area. Securing options for a new project may require negotiating with hundreds or thousands of individual landowners. The option, or assessment period as it is sometimes called, is usually between three to five years and may either appear as a provision in a wind lease or as a separate agreement. If the parties enter into an Option Agreement as a separate document, a wind lease will appear as an attachment to that Option Agreement. Some companies do not do Option Agreements and instead enter into a wind lease that it may terminate if it determines a wind project is not viable. The option period payment, much like a bonus in an oil and gas lease, is usually calculated on a per acre basis. The payment may either be made in full at the outset of the agreement period or on a monthly basis. Some companies prorate the option payments if construction on the wind project begins before the end of the option period. It is not uncommon for an option period to automatically extend if the PTC is not renewed before a certain date or to shorten if the PTC is renewed before a certain date. If the option period is lengthened, the landowner receives additional compensation. An option period is much like the primary term of an oil and gas lease in that it is the period of time during which the lessee determines whether the property is suitable for operations. In the context of a wind lease, during the option period the lessee has the exclusive right to conduct a comprehensive wind study on the property which determines the placement of each turbine for optimum energy production. During this assessment period, an estimate of the expected capacity factor at the property based on an analysis of the wind data collected is done. Capacity factor refers to the percentage of time the wind blows sufficiently to produce energy.12 Utility-scale wind power plants require minimum average wind speeds of about 13 miles per hour.13 The option period also affords the wind company with crucial planning time to decide the placement of substations14 and other wind farm infrastructure. In an oil and gas lease if no drilling or production has occurred at the end of the primary term, the lease terminates and the lessees obligation to drill an initial exploratory well or to do any other development is also terminated.15 Similarly, if after the expiration of the option period the wind study shows the property is not suitable for a wind project or because of other impediments such as permitting problems, transmission interconnection issues or a low power purchase price, either the wind lease terminates or the wind company does not exercise its option to enter into a wind lease. If the wind study indicates that the project is viable, the lease option is exercised and the parties execute a wind lease. If the option period is a provision in a wind lease, the wind lease simply continues in effect.

2.

Installation Fees and Construction Phase

The next stage of the project is the construction phase and depending on the size of the wind farm usually lasts about one year. During this stage the landowner will experience the greatest amount of property usage while the turbines and other necessary infrastructure are put in place. Most leases contain provisions for payments for surface damages should they occur during the construction phase of the project. Some leases include a provision for payments of installation fees based on the number of turbines or other secondary equipment installed on the property. Installation fees may be paid in addition to the bonus but generally appear in lieu thereof. If no turbines or infrastructure are located on the lessors property, and the property is not needed for a wind non-obstruction or overhang easement, the acreage is released and the lease is terminated. 3. Generating Electricity and Royalties

As in an oil and gas lease, a wind lease provides for royalty payments. Unlike in the oil and gas industry, however, a standard royalty payment clause has yet to emerge. Royalty payments or rents can be structured in a number of ways but most are paid out of the amounts received from the sale of electricity to a third party. Just as a lessee who produces gas enters into a gas purchase and sale agreement for the transport and sale of gas, a wind lessee enters into a power purchase agreement (PPA) with a utility that purchases and transports the electricity to the end user. This is an important component to a wind lease as royalties are based on this transaction. Electricity from large-scale wind farms must be transported to the consumer by placing the electricity produced by turbines into the electrical grid through a network of collection transformers and substations for direct sale, typically to a wholesale power provider. 16 The transmission system, or grid, is the farm to market road for electricity.17 The PPA represents the main source of revenue for a wind farm.18 Normally the power purchase agreement is with a utility that is motivated by a regulatory requirement, such as a renewable portfolio standard, to meet its obligation to take electricity under the PPA. Most PPAs are structured to provide revenues to the project company on a fixed or scheduled price basis for a term greater than the term of the project debt financing.19 Owners and lenders prefer to have take-or-pay provisions, which obligate the utility to pay for electricity on a regular basis regardless of whether the utility actually takes the electricity.20 The PPA also should attempt to limit the utilitys right to curtail production, such as only to events of force majeure or emergency situations.21 The PPA may also address construction and operational matters of interest to the lenders, including the consequences of late completion of the facility. Royalty payments are most frequently based on a percentage of the total Gross Revenues received by the Lessee from the sale of electricity under its PPA. The wind lease will include a definition for Gross Revenues which varies depending on the wind farm developers financing arrangements. A commonly used definition provides that the sum of all gross receipts from the lessees sale of electricity generated by the wind farm less any expenses associated with collection of the electricity will comprise gross receipts. Other definitions for Gross Revenues may be more generous and in addition to the total of all gross receipts include moneys received from the sale of renewable energy credits or any type of income from the sale of the electricity.