Key Considerations for CESOP and CHP

June 2008

Potential proponents of new distributed generation or combined heat and power projects are looking at two new programs recently announced by the Ontario Power Authority to provide a platform for getting their projects off the ground. The programs are intended to help potential project developers address risk and develop profitable projects that provide needed power to Ontario, efficiently and cost-effectively. However, when developing proposals under these programs for natural gas-fired projects, prospective developers must give careful consideration to key elements of their gas supply strategy before they submit their proposal to the OPA, to ensure they have taken full advantage of the OPA programs to manage their risks.

The Ontario Power Authority is conducting its second Combined Heat and Power RFP (CHPII) and is in the final stages of developing its Clean Energy Standard Offer Program (CESOP).

The CESOP and CHP programs are attractive to developers because they are designed to ensure approved projects will earn their required returns. To the extent power sales do not provide sufficient revenues, the contract mechanisms in CESOP and CHP are intended to "top up" revenues to match the project's net revenue requirements. However, some key conditions and assumptions are involved.

The Clean Energy Standard Offer Program (CESOP)

CESOP ("see-sop") is designed to address smaller projects with a "one-size fits all" contract methodology. The OPA is trying to keep the program simple, given that proponents of smaller projects typically have fewer resources and can justify less expense in developing their project. The CESOP contract will set out some parameters for a Net Revenue Guarantee that will be available to approved CESOP projects. The Net Revenue Guarantee is based on the value of this kind of generation to Ontario, and assumptions about the efficiency and operating characteristics of this kind of generation. If a prospective project can operate at the assumed efficiency or better and make money at the Net Revenue Guarantee, then proponents will want to proceed with the project.

Combined Heat and Power

The CHP RFP is aimed at district energy and industrial cogeneration facilities of at least 10 MW that may use natural gas, renewable fuels (eg. Wood waste) or by-product fuels. The CHP RFP is 162 pages, and is accompanied by a contract of 217 pages or a power purchase agreement of 164 pages, so it can hardly be described as "simple". It is most likely to attract interest from experienced developers with significant legal and technical resources. Proponents will submit bids showing the fixed revenue requirement of their project, and other parameters such as their contract heat rate(s), start up costs, and variable operating and maintenance costs. The OPA will rank proposals based on the terms bid, and select only those projects that it deems are economic.

Risks in the OPA contracts

The core assumptions behind CESOP and CHP are the same. There is a definition of how much revenue a project needs to earn its required return. There is the assumption about how much of this revenue is earned from market operations (selling power at the market price) and there will be a net payment from the OPA if necessary to cover the balance of the required revenue.

The risks to project proponent arise from two areas:

• The proponent must ensure that the "revenue requirement" established with the OPA for the project truly covers all of the costs the project will incur. Sufficient analysis of the project gas supply strategy must be completed before the OPA bid is submitted to ensure all the costs have been captured. Once the contract is awarded, it's too late to find out that there are costs that were overlooked. If so, the project will be at risk for those costs.
• The proponent must ensure that physical operation will be as profitable as the OPA contract deems it to be. The OPA contract will assume the project operates in certain hours, and will assume that the project earns a certain revenue from that operation. But there will be a difference between the "deemed" operation and the actual real-life economics of physical operation. Proponents must ensure that their proposals address as many of these differences as possible to reduce risk.

There are several potential risks inherent in alternative gas supply arrangements that may not be obvious to project proponents in the early stages of project planning:

• The OPA contract will determine when the project is "deemed" to be dispatched. But actual physical dispatch will not always match this deemed dispatch.
• There will be a difference between the "Dawn daily index" price for gas that is assumed by the OPA and the price that the project actually will pay for gas at Dawn.
• Where the plant is located will affect the cost of gas delivered to the plant. This must be assessed on a project by project basis.
• Whether the plant uses the gas utility's "bundled" or "unbundled" rates will affect gas price risk, and will also have an impact on the resources needed to manage gas supply. Unbundled rates may lower the project risk but increase operating costs since they will require more management.
• Gas costs will have a fixed cost and a variable cost component, and these need to be properly accounted for when bidding to the OPA's contract parameters.

For CESOP projects, these factors must be taken into account to determine whether the project will be profitable. For CHP II projects, these factors must be assessed to ensure that the CHP proposal properly captures all the costs, so that the contract, if awarded will be a profitable one.

CESOP, in particular, may be of interest to proponents with "one-off" project opportunities. These may be commercial or institutional complexes, such as hospitals or municipalities, that offer potential for district energy applications. There is a good chance that CESOP proponents are not experienced in district energy project development, creating greater risks that some elements of successful project planning may be overlooked. If you are considering a potential project under the CESOP or CHP II program, consider looking to resources such as the Canadian District Energy Association for assistance in identifying the key risks and variables for your project.  A link to the Canadian District Energy Association's resources page appears at the bottom of this article.

If you have questions about assessing gas cost risk within CESOP or CHPII projects, contact John Voss at jvoss@aegent.ca .

To access the Canadian District Energy Association's resources page, click here >>