The Top Five Traps in Energy M&A Transactions
Energy M&A transactions require counsel with specialized knowledge of the energy business, project or portfolio of projects being acquired or sold. Such knowledge requires deep understanding of the energy industry across many legal disciplines, including general corporate, tax, energy regulatory, environmental, health and safety, employee benefits, real estate and often international. Without this understanding, parties to energy M&A transactions may find themselves hindered by the following common problems.
1. Lack of a Broad Knowledge Base
The energy industry is highly complex, with varying market structures and regulations throughout the world. As a result of this complexity—particularly the energy, environmental, health and safety, and other regulations affecting the industry—energy M&A transactions are rife with risk that is difficult to identify, navigate and understand. Failure to adequately identify and understand the level of risk involved in a transaction may result in dire consequences, including overvaluation of the business or assets being acquired, limitations on the intended use of the assets after closing, fines, penalties and other unforeseen liabilities.
While some issues may be common to the energy industry or a specific segment thereof, issues and risks more often than not vary across the industry, or even a segment of the industry, based on location and the type of business or asset. For example, the power generation business is subject to completely different regulations and market structures depending on the state and region where a power plant is located. Some parts of the United States have regulated markets, and others have deregulated markets. The nature of these markets may differ substantially depending on the structure, rules and regulations established by the relevant Independent System Operator or Regional Transmission Organization, the applicable state’s public utility commission (PUC) and the Federal Energy Regulatory Commission (FERC). Further, natural gas fired, coal fired, wind, solar and biomass power projects each have their own unusual issues, risks and concerns. The power generation business is but one example. The energy industry as a whole is exceptionally complex, and each business, asset and jurisdiction—regardless of the energy industry segment—will often have unique regulations, rules and market structures.
The energy industry is further complicated by the commercial arrangements in which energy businesses are involved. The large capital outlays involved in these transactions warrant a detailed due diligence review that complements the business team’s evaluation of the business being purchased, including complex project finance documents; performance and efficiency guarantees (e.g., heat rates, availability guarantees and other performance metrics); tying input and output risks; hazardous substance arrangements; gathering, processing and refinement of hydrocarbons; transportation agreements; and interconnection and transmission rights and agreements. To ensure a successful M&A transaction, the person performing this review should have the knowledge necessary to identify the pertinent information, issues and risks associated with these industry-specific complex commercial arrangements.
2. Misunderstanding Risks Involved with Project Based Assets
Many energy industry M&A transactions involve projects, portfolios of projects or development assets. The value of each individual project is driven by the cost of its operation, including fuel supply, and the revenue generated by its assets. The due diligence process should evaluate each side of this equation in order to provide a clear picture of the legal, regulatory and economic health of the project. In addition, projects often have their own financing, interconnection rights, permits and real property rights, each of which may have a material impact on the operation or performance of the project. Finally, development assets present their own risks and vary depending upon the relevant assets’ development stage. Special care should be given to identifying and analyzing the risk associated with the completion, construction, commissioning and operation of such assets.
Fuel supply, warranty agreements, operation and maintenance, and other material agreements affecting the cost of performance should be reviewed and evaluated to determine the legal, regulatory and commercial risk involved in such agreements, including potential increases in the cost of the performance of the project over time, anticipated deterioration in performance, and the adequacy of fuel supply, replacement parts and other inputs. This analysis should include the identification of material exposure or weakness in these commercial arrangements, including issues in availability guarantees, response times, fuel delivery, minimum commitments for parts or fuel, and other hidden costs.
A project’s revenue contracts are crucial to the value being assigned to a project. Performance guarantees, credit support requirements and credit exposure, off-takers’ rights to refuse performance, early termination rights and the allocation of risk between the parties for force majeure, curtailments and other uncontrollable risks must be indentified and understood in order for the business team to evaluate the project’s revenue stream.
Project companies are often subject to other legal or commercial arrangements that affect their operation and performance, including project financings, transmission or transportation agreements, interconnection agreements, permits and real property rights. The covenants in these various agreements can influence the project company’s ability to operate its assets and perform its obligations under its fuel supply and revenue contracts. Therefore, material issues within such arrangements should be identified and analyzed when assessing the overall value and risk associated with the project.
Finally, energy M&A transactions often involve the acquisition of development assets. In these situations, the purchaser often assumes the additional risk that the project will be capable of being completed. The due diligence process is critical in evaluating the level of development and other work that must be completed before the project can be constructed, commissioned and placed into service. This includes evaluating the risk of delay in obtaining permits and other governmental authorizations; completion of the project interconnection; and obtaining adequate transmission, transportation or other rights necessary to timely complete the project.
3. Difficulty Identifying Energy Regulatory Issues
The energy industry is highly regulated and requires numerous local, state and federal licenses, permits and approvals in order to operate. A business may be the subject of enforcement or other proceedings in front of FERC, a state PUC or another regulatory commission. Regulatory issues and material proceedings affecting a business or transaction should be identified in the due diligence process and adequately addressed and understood by the parties prior to entering into the purchase and sale agreement.
The regulatory knowledge required for an energy M&A transaction will depend on the business or assets being purchased and acquired, and the jurisdiction in which they are located. For example, M&A transactions involving interstate natural gas pipeline projects will require FERC experience that differs from the FERC experience required for M&A transactions involving power generation and transmission assets. Additionally, each state adds its own regulations through legislation, PUCs, railroad commissions or other authorities. Accordingly, the regulatory advice needed for a transaction will depend upon the nature of the business being purchased and sold, and the location of its assets.
Finally, regulatory approvals and notices may be required for certain types of M&A transactions. For example, Section 203 of the Federal Power Act requires FERC authorization for mergers, dispositions and acquisitions involving electric generation and transmission companies. Section 1289 of the Energy Policy Act amended section 203 of the Federal Power Act and expanded FERC’s authorities and requirements. The right regulatory advice can be critical to navigating these and other approvals and authorizations.
4. Missing the Full Legal Picture
The laws and regulations affecting the energy industry go beyond the energy regulatory regime and include environmental, health and safety, tax, employee benefits and real property issues. Therefore, energy infrastructure M&A transactions often require the support of skilled professionals in environmental, health and safety, tax, employee benefits and real estate law in order to provide a complete picture of the risks to a business or project.
Coal, natural gas and nuclear power plants, as well as upstream, midstream and downstream oil and gas assets, all are faced with their own unique environmental challenges, including emission permits, potential carbon and frac fluid regulation, and pre-existing conditions and liabilities associated with releases of mercury, petroleum, radiation and other potentially environmentally hazardous substances. Even renewable energy projects face stringent environmental regulations related to preserving wetlands and mitigating the impact a project may have on animal and plant life. Equally important is the identification and analysis of issues relating to the health and safety of workers; the tax structure of the transaction; depreciation rights; and, in the context of renewable or nuclear energy projects, qualification for tax credits and treasury grant programs, ERISA, employee benefit liabilities and real property rights. Accordingly, knowledge covering a wide range of the law is necessary for a complete picture of the risks and liabilities involved in an energy M&A transaction.
5. Inadequate Identification of International Exposure
Oil and natural gas are global commodities, and energy companies frequently do business around the world. Accordingly, energy M&A transactions often involve projects, assets or businesses located in foreign jurisdictions. The rules and regulations affecting the energy business vary widely around the globe, and local professionals should be engaged to assist with M&A transactions involving foreign operations in order to properly understand these differences. Similarly, international transactions may involve additional U.S. legal issues that should not be overlooked, such as compliance with the Foreign Corrupt Practices Act.
The market structure, regulations and commercial arrangements associated with the energy industry are complex and varied. The right skill and understanding of the business involved is crucial to successfully identifying, navigating and addressing the risks associated with energy M&A transactions.