Avoiding Pitfalls in Combined Heat and Power

Growing concern over global climate change and tropical storm Sandy’s widespread power outages highlighted the nation’s vulnerable and aging power infrastructure. Distributed generation provides reliable, on-site energy of growing interest. Favorable natural gas supply and prices, rising base rates for retail electric service under established tariffs, and more favorable regulatory schemes promoting distributed generation, all mean that the time has come for a rapid proliferation of combined heat and power (CHP) installations in the U.S.

When President Obama issued Executive Order 13624, “Accelerating Investment in Industrial Energy Efficiency” in August, 2012, independent energy producers, financial investors and industrials with energy-intensive manufacturing operations, such as chemical, paper product, and refining companies took notice. The order aims to accelerate investments in industrial energy efficiency, including CHP projects, setting a national goal to reach 40 GW of new CHP capacity over the next decade.

CHP’s Relevance

CHP projects use a single fuel source to generate both electric power and useful thermal energy (whether it takes the form of steam, heated or chilled water, or compressed air) for heating and cooling. Manufacturers and commercial end-users with a large coincident demand for electric power and some form of thermal energy should consider CHP to gain efficiencies over legacy configurations, where the commercial or industrial energy consumer buys electric power from the grid and makes steam or heat from an on-site boiler or furnace. Configured properly, a CHP facility would generate the same amount of electric and thermal energy as the legacy system, but more efficiently.

The value of a CHP project is tied to its ability to generate two sources of energy simultaneously, so most CHP projects are sized based upon a host facility’s thermal base-load requirements. This typically favors industries with intensive heat or steam demands. Also, waste heat recovery—which should be distinguished from traditional CHP—can be an added component to a CHP system configuration to capture additional heat, generally wasted, from a host’s manufacturing processes. Where an end-user has a sizeable thermal load and is paying high electric production prices, but has access to cheap natural gas (or other applicable fuel sources), CHP has the potential for significant cost savings in addition to efficiency and reliability benefits. 

While CHP is an attractive option, the design, construction, ownership, operation and maintenance, and sale of energy commodities from CHP projects are filled with potential pitfalls for end-users. Technology choice and construction/operational risk; cost overruns; fuel cost and supply; market fluctuations; change in law risk; environmental exposure; site specific concerns; regulatory constraints, and force majeure events are all meaningful risks to the viability of a CHP project. Four general principles should govern an end-user’s decision in evaluating the feasibility of a CHP project for one or more of its manufacturing or commercial sites.

Reliability

The primary driver behind the revitalization of CHP in the United States is the quest for increased reliability to meet end-users’ electric and thermal load requirements on a continuous basis. Reliability is best delineated by how often and how long energy service is interrupted. Any disruption of electric or thermal energy input could yield catastrophic consequences for manufacturers, hospitals, data centers, or other sensitive end-users in the form of lost revenues, endangerment to health, and the damage or destruction of expensive manufacturing equipment. 

Configured properly, CHP plants can run at a high capacity and provide reliable, continuous electric and thermal energy to mitigate the potential hazards associated with a sometimes-unreliable electric grid and offer meaningful cost savings at the same time. When designing a CHP project for behind-the-meter generation, end-users should take great care in assessing reliability, including minimum performance standards, thermal load redundancies (such as back-up boilers), and heat recovery steam generator and auxiliary boiler efficiency. The risks associated with a failure to meet negotiated reliability standards become especially important when a CHP project is sized to sell excess energy back to the grid or to more than one end-user.

Ownership and Operational Models 

A second consideration in assessing the viability of a CHP project centers on whether the end-user will incur out-of-pocket costs in designing, constructing and operating a CHP facility. Most industrial and commercial end-users are not in the energy generation business, and they don’t wish to invest in non-core business assets. Energy managers must achieve early consensus from their finance and risk departments on whether their company is interested in risking capital in a CHP project. Luckily, a number of ways exist to structure a CHP project so that the host may reap the benefits related to dedicated energy resources without a significant capital investment.

No “one-size-fits-all” model fits with the development of CHP projects. Some hosts seek merely to be the off-taker under a long-term energy services arrangement, where a third party develops, builds, owns, operates, and maintains the CHP facility. Others may be interested in soliciting third parties to develop, build and subsequently transfer a CHP project to the end-user upon commercial operation. A third alternative, which we have negotiated on behalf of end-users, is a joint venture arrangement where the end-user takes a minority or majority interest in a special purpose vehicle specifically created to own and operate the CHP facility. The structure ultimately chosen will have a direct impact on a third party’s expected return on investment and the allocation of risks between the parties involved.

Risk-Adjusted Pricing: Forests and Trees

A common misconception among end-users assessing the viability of a CHP project is that the price of the energy commodities being generated and delivered should be measured on a standalone basis against the end-user’s current electric and thermal energy pricing. While in some cases as CHP project can yield significant cost savings over a consumer’s current electric tariff and separate thermal energy arrangements, the real value of a well-designed project is the opportunity for an end-user to shift many of the risks to a third party CHP provider. Also, reliability concerns can be further alleviated by shifting any emergency/backup energy system redundancies or energy replacement costs to third parties in the event there is an operational issue with the CHP facility. End-users must appropriately weigh the ultimate cost of the energy commodities they expect to receive from a CHP facility against their current pricing arrangements without losing sight of the reduced risk profile they are assuming.

Applicable Regulatory Framework

Finally, any feasibility assessment of a CHP project must include an analysis of the federal, state, and local laws and regulations impacting the permitting, development, construction, operation, and purchase and sale of energy commodities from the project. One regulatory consideration is whether a state in which the CHP project will be sited regulates the sale of electric power, steam, and other forms of thermal energy “across the fence” from a third party owner/operator to a host consumer. Some states have exemptions for self-generation (where the host owns and/or operates the CHP project for self-consumption). But in states that regulate sales, the parties involved must be careful when structuring the project and understand the implications of being deemed a “public utility” under law.

Additionally, some states permit net metering for unused load back-fed onto the grid by a CHP facility. The ability to net meter may constitute an important economic benefit to the CHP project. On the flip side, in some states local electric utilities may charge “exit fees” or otherwise increase the electric tariff pricing for emergency power where a host is removing all or a significant portion of its electric load from the utility’s system. These potential revenues or costs should be considered when assessing financial models for a CHP project.

States are moving towards adopting regulatory frameworks favorable to CHP, and the President’s recent executive order certainly encourages these efforts. Examples of such favorable regulations include certain states expanding their renewable portfolio standards (RPS) to include forms of CHP or waste heat recovery and other states recently passing legislation to expedite the permitting process for CHP facilities.

Industrial and commercial end users must carefully weigh a number of factors, issues and considerations must be carefully when determining the feasibility of a CHP project. Among these: structuring considerations, risk tolerance and institutional preferences, technology types (e.g., reciprocating engines, turbines, fuel cells), optimal CHP sizing configuration in light of market pricing dynamics and regulatory constraints, legal compliance matters and host/site specific considerations. All play an important role in the decision-making process. Selecting outside technical consultants and legal counsel with the requisite experience and expertise in CHP projects is critical for the host to ensure that a thorough and well-reasoned feasibility analysis is performed.

—Ram C. Sunkara is a partner, and Jackson M. Allen is an associate, of the Energy and Environmental Practice Group at the law firm of the Sutherland Asbill & Brennan LLP.