Reducing Risks, Building Legal Precautions in Energy Contracts

Despite its strong recent growth, the energy sector is going through uncertain times due to regulatory issues, which erode the trust of players aiming to close long-term power purchasing agreements (PPAs). Although this uncertainty remains a reality, it is possible to continue doing business in the energy sector by taking all legal precautions and understanding the nature of contracts to mitigate risks, agreed industry experts.

“There are several contracts that were signed a long time ago, when situations such as the pandemic or the current electricity reform proposal were almost unimaginable. Contracts must be structured to protect both parties. The main concern is to understand everything about contracts, including their implications. It is vital to comprehend all its components from the very beginning, as well as its future scenarios and risks,” said María José Treviño, Country Manager, Acclaim Energy.

The number of energy companies competing in the Mexican energy market has grown exponentially over the past years. New available options created different contract risks. Other more external factors, such as the Ukraine and Russia conflict elevating gas prices, higher exchange rates and rising inflation caused further threats to stability. All this risk must be shared between the seller, buyer and intermediaries, said Diego Arriola, Founding Board Member, NxtLab. Getting rid of Mexico’s pre-2014 Energy Reform legacy self-supply contracts therefore makes sense, since these contracts are outdated. “The migration toward the new Electricity Industry Law (LIE) was expected. Self-supply contracts have a deadline defined in the interconnection contract, too. PPAs must be transformed optimally way to distribute risks,” Arriola said.

The first set of risks in energy contracts includes factors affecting the base level of fees charged, including their credit, billing and renewal. Another important decision is whether to make short-term or long-term contracts. Currently, legal uncertainty is driving players to prefer short-term commitments, which create the opportunity to sign up when rates are low and offer greater flexibility to shop around for better rates when contracts run out. Long-term PPAs offer stable and predictable rates, but require a greater level of commitment, according to Constellation. Even climate change itself has become an additional risk regarding changing contract terms, pointed outEdmond Grieger, Partner, Von Wobeser y Sierra.

The Mexican energy market evolved rapidly and already boasts a lot of investment and strong internal competition. However, it is still not a buyer’s market, said Santiago Villagomez, CEO, Energía Real. “It is a strange situation for the sector. Legal uncertainty is driving all players to more complicated negotiations and contracts with different terms.” Regarding distributed generation (DG), Villagomez explained that short-term commitments are thwarting business due to DG’s unique offer compared to self-supply and qualified supply. “When clients ask for shorter terms, it becomes complicated. In DG, you must be able to amortize the investment for a particular project on the long term.”

Qualified supply is the supply of electricity within the wholesale electricity market (WEM) to industrial customers who have electricity demands over 1 MW, explained Lilian Alves, Director of Strategic Planning, Mitsui & Co. Power Americas. Contracts must be revised with close attention, she agreed. “You must consider the environment and current uncertainty. Both client and supplier should be aware of the situation and understand the contract they are signing.”

Sometimes, clients need help to understand all the components within contracts, said Alves. “We translate concepts and make comparisons for clients so that they feel more comfortable with what is written.” Mitsui also runs simulations of bills before signing contracts. “These simulations cover normal cases, aligned with what is expected, as well as unplanned phenomena such as a higher gas price or increased CFE rates. The simulations allow the client to understand the contract, providing them with knowledge so that they feel more comfortable throughout the contract’s term.”

Navigating the Mexican energy market is no easy endeavor. However, having internal organization, external support and access to the right advice can help companies reduce costs, mitigate risk and secure an improved energy reliability, said Treviño.

PPAs must be explained to clients by outlining their consumption profile, the product they buy, the final price to be paid and possible penalties in case the contract is canceled. Further information regarding permits and regulations, as well as about factors like force majeure situations or regulatory changes should also be provided, said Arriola. Understanding and future-proofing contracts in the energy sector is more important than ever amid global uncertainty, settled the energy experts.