In a July 25, 2019 order, the Federal Energy Regulatory Commission (FERC) directed PJM Interconnection, L.L.C. (PJM) not to conduct the Base Residual Auction (BRA) to procure capacity for the 2022–23 delivery year in August 2019 and instead to wait until FERC prescribes a remedy for the flaws in PJM's buyer-side market mitigation rules identified in its June 2018 order (see Calpine Corp. v. PJM Interconnection, L.L.C., 168 FERC ¶ 61,051 (2019) and Legal Update, FERC Orders PJM Capacity Auction Delay).

The delay of PJM's BRA may have unintended—and, from a project sponsor's perspective, unfortunate—implications under existing construction financings for certain recent gas-fired combined-cycle generation projects in PJM, and may force the postponement of new financings and re-financings of these projects. The delay also has potential implications for valuing acquisitions and bilateral capacity trades that have fixed or floating swap components.

Some recent transaction documents contain market disruption provisions addressing a scenario in which PJM's BRA results are not available, but such provisions appear to be much less prevalent in credit agreements. The exclusion of PJM's BRA results in the calculation of the "target debt balance" under these credit agreements may result in "artificially" increased excess cash flow sweeps starting with the third quarter of 2019 when the rolling three-year aggregate projected capacity revenues include the first material period impacted by the delay.

Proactive sponsors and lenders will review their credit and hedge agreements with their counsel to ascertain the potential impact on excess cash flow sweep obligations and valuations, and initiate discussions on how to resolve (by amendment or otherwise) any unintended consequences resulting from the delay in (or suspension of) PJM's BRA.

In the June 2018 order, FERC found that PJM's capacity market rules were unjust and unreasonable because they did not adequately address the price-suppressive effect of subsidized new and existing resources. FERC established a "paper hearing" to consider changes (for example, a "replacement rate") that would remedy these flaws (see Calpine Corp. v. PJM Interconnection, L.L.C., 163 FERC ¶ 61,236 (2018) and Legal Update, FERC Order on Subsidized Generation Could Remake PJM Capacity Market). That paper hearing concluded with the filing of responsive pleadings and testimony in early November 2018. In a separate order issued in August 2018, FERC granted PJM's request to delay the 2022–23 BRA, originally scheduled to be held in May 2019, until August 2019 (see PJM Interconnection, L.L.C., Order Granting Waiver, 164 FERC ¶ 61,153 (2018)).

FERC has not yet issued an order on the merits of a potential replacement rate, and the July 2018 order gives no indication as to when it may act, stating only that "delaying the auction until the Commission establishes a replacement rate will provide greater certainty to the market than conducting the auction under the existing rules" (see July 2018 Order, 168 FERC ¶ 61,051 at p.14).

Since 2014, some term loan A construction financings for projects in PJM determine the amount of excess cash flow applied to prepay the loans for a given quarter using a dynamic calculation based in part on the results of PJM's BRA. By contrast, the sweeps in term loan B deals are usually a fixed percentage, which give sponsors more certainty as to the amount of distributions they can expect to receive on a quarterly or semiannual basis (see Practice Note, Sources of Available Project Financing: Term Loan B Facilities).

In term A loans, the excess cash flow sweep is typically equal to the amount required to achieve the lesser of:

Lenders treat PJM's BRA results as a three-year rolling capacity contract with a creditworthy offtaker. But, if such results produce aggregate projected capacity revenues that are worse than the "base case" reflected by the Target A Debt Balance, then the target debt balance toggles to the Target B Debt Balance calculation and the excess cash flow sweep increases to reflect the deterioration of the project's revenue outlook. This means that more cash flow is used to repay debt with less cash flow available for distributions.

As discussed above, credit agreements that feature Target B Debt Balance mechanics do not typically address a situation where PJM's BRA results are unavailable. Without these results to "plug into" the calculation, the determination of the Target B Debt Balance and, therefore, the amount of the excess cash flow sweep for a given quarter are, at best, uncertain and, at worst, artificially increased. For example, zero capacity revenues might be attributed to the affected period, resulting in a lower Target B Debt Balance, or the Target B Debt Balance might be indeterminate, an outcome that is not addressed under the credit documentation.

Depending on the replacement rate FERC eventually approves, the clearing prices may or may not be higher than such capacity prices would have been under PJM's existing capacity market rules. Since it seems almost certain that PJM's BRA will eventually be run, attributing zero capacity revenues to the affected period or concluding that the Target B Debt Balance is indeterminate could result in artificially increased excess cash flow sweeps beginning with the third quarter of 2019. The payment for such amounts at the level in the cash flow waterfall for mandatory prepayments means less funds for the subsequent levels of the waterfall—notably, less funds available to sponsors as returns on their equity investment.

In light of the potential issues described in this Update, sponsors, lenders, and counterparties to derivative and hedging transactions should proactively discuss the impact of the delay of PJM's BRA and work towards a consistent approach across the affected construction financings of projects in PJM.