Power purchase agreements: how the contract works

A power purchase agreement is a long contract in which a buyer, the offtaker, agrees to pay a power producer for capacity, energy or both. For an independent power project it is the single most important document, because the producer's lenders lend against it. If the PPA is weak, the project cannot raise debt. If the offtaker is weak, a strong contract is only as good as the paper.

Who signs

The producer is normally a special-purpose company set up to build and operate one plant. The buyer is often a state utility, a transmission company or a distribution company, although corporate buyers now sign PPAs with generators too. The World Bank's PPP Knowledge Lab publishes a sample PPA for an oil-fired complex, marked as a reference only and not a model. In it, the utility is a host-country company assumed to be government-controlled, and the company is the supplier that designs, finances, builds, owns, operates and maintains the plant. The two documents around the PPA often matter as much: a fuel supply agreement and a government support or implementation agreement.

How the buyer pays

Most utility PPAs split the price in two. A capacity payment is made for having the plant available, and in the World Bank sample it equals the capacity purchase price multiplied by the dependable capacity, paid monthly (Section 9.1.1). An energy payment is made for each kilowatt-hour actually delivered, at the energy purchase price (Section 9.2.2). Before commercial operation, the sample has the utility pay the actual fuel cost of the commissioning energy.

The split matters because capacity payments are what services debt. A producer paid only for energy delivered carries the risk that the grid will not call on it. The sample PPA illustrates the point: it says the utility is not obligated to request any net energy output, so the capacity payment carries the revenue that does not depend on dispatch.

Two terms from other PPAs are worth knowing. Take-or-pay means the buyer pays for a minimum quantity whether or not it uses it. Deemed energy is energy the plant could have delivered but the buyer chose or was forced not to take, and the buyer pays for it as if it had been delivered. The World Bank sample does not use deemed energy, so check each PPA for how it treats curtailment, particularly for wind and solar, where the plant's output depends on the weather.

Indexation and currency

The price rarely stays flat for twenty years. The sample provides that capacity and energy prices, liquidated damages and security amounts are adjusted according to a schedule. In a typical project part of the tariff is indexed to a foreign currency, part to local inflation and part to fuel cost. The producer wants the indexation to match its cost base and the currency of its debt. A mismatch, such as dollar debt against a local-currency tariff with weak indexation, is a classic way for a project to fail in a devaluation.

Credit support: what if the buyer does not pay

The sample requires the supplier to post construction security before financial closing and operations security from the commercial operations date, both as unconditional irrevocable letters of credit. It also requires the utility to maintain irrevocable, revolving letters of credit covering capacity and energy payments (Section 9.7). The authors assume the government will guarantee the utility's payments through an implementation agreement, and they flag that as an assumption, not a term of the PPA.

Lenders examine the offtaker's credit before they look at the plant. Where it is weak, they ask for a sovereign guarantee, a payment security mechanism, a partial risk guarantee from a development bank, or political risk insurance. These tools reduce the risk, they do not remove it, and each has conditions that can lapse.

Risk allocation: delay, performance and force majeure

The sample charges liquidated damages for late commissioning, capacity shortfalls and dispatch failures (Section 9.3), and the parties waive any argument that those damages are penalties. It divides force majeure into natural events and political events. The supplier receives no capacity or energy payment during natural force majeure or foreign political force majeure, but for host-country political events it may keep receiving capacity payments for a limited time (Section 13.3). Change in law and lapse of consent appear among the host-country political events.

The World Bank Group's report on recommended PPP contractual provisions takes the same logic further. It treats force majeure as a risk that should not fall on one party alone, notes that a prolonged event, typically six to twelve months, may let either party terminate, and puts material adverse government action on the public side, because the private partner cannot control it. On change in law, it presents two options, one that protects against all changes and one that protects only against discriminatory, specific and certain capital-cost-related general changes.

Termination payments

This is where the contract meets the loan agreement. If the buyer defaults, or a prolonged government action ends the project, the report says payment generally covers the outstanding senior debt, redundancy and subcontractor breakage costs, and the equity invested, plus a return on equity calculated in one of three ways: the original base case internal rate of return, market value, or the net present value of forecast distributions. If the supplier defaults, compensation is often limited to debt with a haircut, and the report brackets figures of 80 to 85 percent as an example, with market value recommended where the asset is liquid. In prolonged force majeure, the report suggests senior debt, a percentage of equity and costs, but not lost future revenue.

Lenders read the termination schedule first because it tells them whether they get repaid if the project ends. Investors read it for the same reason, and for what the equity return looks like if the buyer is the one who breaks the contract.

What to check before you commit

• The offtaker. Its credit, its payment record, and any guarantee behind it.
• The term and the price. Length, structure of capacity and energy charges, and how indexation works.
• Dispatch and curtailment. Whether the buyer must take the energy, and who bears the cost if it does not.
• Security. Letters of credit, escrow and replenishment rules, and what happens when they lapse.
• Change in law and political events. Who bears the cost and for how long.
• Termination. Compensation formulas, which defaults trigger them, and the lenders' step-in rights.
• Interconnection. Who builds the line, who is late, and who pays for the delay.

A PPA that scores well on each point still needs local legal review, because the enforceability of a clause depends on the country's courts and the governing law the parties choose.

Guides explain how things generally work. They are not legal, tax or investment advice for a specific project or country. See our editorial policy.