BESS Opportunities in Chile

Battery storage projects cannot come soon enough for Chile. While Chile has been at the forefront of renewable energy generation growth in Latin America for close to a decade, that growth has most recently undergone serious growing pains. A number of renewable energy projects in Chile supported by distribution-company-auction power purchase agreements (the "DistCo PPAs") have been adversely affected by "decoupling" or location basis risk. This risk has proven particularly tricky to size and mitigate in Chile because, under the DistCo PPAs, the cost to purchase energy at the nodes at which the energy is required to be physically delivered by the project to the offtakers at a large number of locations across the country can prove to be higher and has, in many instances, proven to be much higher than the price at a project's injection node on the basis of which the project's revenues are derived, due in large part to transmission congestion and radically different supply and demand profiles across regions with limited interregional transmission. This revenue/cost price decoupling has yielded negative operating cash flows for numerous renewable energy projects, sometimes for a prolonged period of time. Projects with DistCo PPAs that were project financed on a single-asset basis have been disproportionately impacted as the revenue/cost mismatch is wholly undiversified in those cases. Generation companies with portfolios that have diversified offtake regimes, project locations and technologies, on the other hand, have been able to better absorb the impact of the financial stress of the decoupling.

In the context of the financial stress caused by the DistCo PPAs for many renewable energy projects, owners of existing projects and new entrants are racing to develop battery energy storage systems ("BESS") that are integrated into, or co-located at, the generation site. These BESS systems would allow renewable energy projects, especially solar projects in the North of Chile, to take advantage of much higher prices at their nodes of injection in the evenings.

Being mindful of the challenges to its energy grid, the Chilean government has moved fairly quickly to advance regulatory reforms to facilitate BESS investment opportunities. Pursuant to Law 21,505, the Chilean Ministry of Energy has proposed to amend the regulations on capacity payments to allow for those payments to be applicable to energy storage systems. The proposal is expected to be approved by the Office of the General Comptroller this year and includes recognizing capacity payments for "stand-alone" energy storage systems, recognizing higher capacity payments for storage systems with longer hours of capacity, providing separate capacity payments for generation and storage facilities for hybrid installations that house both facilities and allowing the withdrawal of energy from the grid for the loading of connected storage systems. Another recent Chilean regulatory reform to facilitate BESS investment opportunities was the approval of auctions to award public lands for the development of BESS projects. Earlier this year, the Chilean Congress also began discussions to amend its energy transition bill to hold large-scale BESS auctions. The foregoing conditions and governmental actions have resulted in a potential BESS pipeline in Chile of over 6GWs.¹

When investing in Chilean BESS projects, especially those to be leveraged through limited recourse financing, investors and owners should carefully consider certain key project elements such as curtailment risk, grid connection delay risk, lithium supply chain stresses, battery performance warranties, contracted vs arbitrage vs hybrid revenue models and various technical risks associated with the technology's relatively new deployment. Many of these risks have already materialized in other jurisdictions where the implementation of battery storage technology has advanced earlier than in Chile, such as Australia and the United States. Risk mitigants that have been evolving and implemented in those markets will be relevant in the Chilean context, as described below.

Key BESS Risk Considerations

In view of experiences in other markets that have so far led the deployment of BESS systems, investors should carefully examine, among others, the following key risk considerations when contemplating BESS investment opportunities: (1) the availability of supplies; (2) battery performance warranties; (3) revenue models and agreements; and (4) technical reliability considerations.

1. Availability of Supplies

Potential vulnerabilities of the global battery supply chain will be an important consideration for sponsors and lenders in BESS projects.

Lithium-ion batteries are currently the predominant technology for battery storage, with lithium and cobalt being key raw materials used for its production. While Chile is one of the largest producers of raw lithium globally, China is responsible for over half of the global processing of lithium and cobalt. China also dominates the global production of battery cells. This division of labor is unlikely to change for the foreseeable future.

The concentration of the production and refining of raw materials and battery manufacturing heightens the exposure to disruptions in the global battery supply chain. In 2022, for example, the Russia-Ukraine war resulted in tariffs and other trade restrictions being placed on nickel sourced from Russia, and a concomitant surge in the price of nickel. Trade sanctions, export restrictions or other disruptions in producing countries may have similar impacts on the price of lithium or cobalt in a volatile international geopolitical context, although that risk will certainly be mitigated if production takes off in Chile, Bolivia, Argentina and Brazil.

These global geopolitical and production-interdependence factors resulting in lithium battery supply shortages, coupled with increased international demand, have in turn yielded significant price fluctuations in lithium carbonate in recent years. To address price uncertainty risk, we have seen parties to a BESS EPC contract or BESS supply contract agree to lithium carbonate price adjustment mechanisms such that lithium price increases, occurring during an agreed adjustment period and which exceed a particular monetary threshold, are treated as a sponsor or owner risk.

2. Battery Performance Warranties

Lithium battery performance degrades over time due to the naturally occurring decline of available capacity caused by wear and tear and irreversible chemical reactions resulting from their normal use. Therefore, a key legal instrument to mitigate against the risk of profit loss due to higher-than-expected degrees of battery degradation is obtaining robust battery performance warranties from the battery manufacturer. Such battery performance warranties can guarantee that the batteries used for a given BESS meet certain manufacturing quality and performance capability standards. Typically, BESS suppliers will provide for an energy retention warranty over a specified term allowing for fixed energy retention percentages per year that decline in incremental percentages for each subsequent year of the warranty period. Breaches of such warranties would then trigger a BESS supplier's obligation to undertake repair or replacement services to ensure the BESS achieves or exceeds the minimum energy retention levels warranted in the applicable year. Careful technical, commercial and legal due diligence should be undertaken of such warranty regimes and exclusions to such warranties particularly in the context of any commitments separately made under any offtake arrangements regarding contracted output and capacity commitments to ensure alignment across core project agreements regarding BESS performance. The duration of any performance warranties provided by the BESS supplier should also align with the terms of any offtake arrangements entered into by the project company, with protocols put in place to ensure the diligent and timely enforcement of such warranties to ensure prompt rectification of any BESS deficiencies. Lenders and investors will expect to see contracts put in place with experienced BESS operation and maintenance contractors to ensure the optimization of the BESS through careful compliance with the required operating procedures and any local law requirements. A coordinated handover process between the construction and operation phases of the BESS development should also be outlined in the EPC and O&M contracts (including with respect to the preparation of O&M manuals, the training of personnel and commissioning obligations), particularly where such contractors are unrelated entities.

Importantly, the performance liquidated damages package under the BESS supply agreement should be adequately sized having regard to any project finance debt being incurred for the applicable project and, together with the performance security packages under the related project agreements, sufficient to buy down a proportionate amount of the debt if required.

As the battery manufacturers are often located overseas from the BESS project utilizing the batteries, it may be prudent for investors to also consider how to enforce battery performance warranties against foreign manufacturers. One way to address such cross-border enforcement risk is to have a liquid instrument (such as a letter of credit) standing behind the obligation to pay any performance liquidated damages. Another option is to obtain a credit-worthy corporate guarantee from the BESS supplier's parent company covering the warranties having regard to the location, nature and extent of such parent company's assets and the likelihood of local courts enforcing any arbitral award relating to the enforcement of such warranty in the event of a dispute.

3. Revenue Models and Agreements

Revenue models for BESS are typically described as "revenue stacking," or assembling revenues from a variety of sources. Such sources of revenue include: (1) capacity payments; (2) electricity sales under a PPA (defined below); (3) payments under tolling or other similar arrangements; (4) arbitrage, i.e., selling energy during non-peak generation times, typically at higher prices; and (5) ancillary services, such as voltage and frequency regulation.

Agreements such as tolling agreements and Power Purchase Agreements ("PPAs") can harness the aforementioned revenue sources. Through tolling agreements, BESS projects may source power from utility offtakers through a tolling arrangement in which the offtaker or charging energy supplier retains title to all stored energy. Through PPAs, BESS projects may sell power to consumers, especially during nighttime hours when renewable power generation is less feasible. These PPAs can have fixed prices or be structured in any number of ways with great flexibility to the specific positioning of a project.

4. Technical Operational Safety and Reliability Risks

BESS projects involve certain technical operational safety and reliability risks that require careful consideration of appropriate mitigants. Such technical considerations include thermal runaway risk, the potential of mechanical, electrical or control system defects, and the related possibility of fire risks. Thermal runaway occurs when batteries in a BESS release heat during operation, causing a feedback loop of battery damage and rapid heating. Thermal runaway can be minimized by implementing certain design features in the construction phase that interrupt energy transfer between adjacent electrochemical cells. Mechanical, electrical or control system defects may also occur in BESS projects, sometimes exacerbated by thermal runaway, which may lead to fire hazards.

These technical risks can be managed through precautionary measures in the manufacturing and construction stages, the installation of built-in fire protection systems such as automatic fire suppression mechanisms and cooling systems, adherence to proper operating standards, and the procuring of adequate insurance. Other tried and tested mitigants include the implementation of rigorous testing protocols and diligent technical oversight in the design and manufacturing process including though early engagement with local fire services to ensure compliant BESS design.

Conclusion

The Chilean renewable energy landscape and recent regulatory reforms promoting the development of energy storage systems have made Chile a ripe market for BESS investment opportunities. Potential investors should consider certain unique risk factors for BESS projects including the availability of supplies, battery performance warranties, revenue models and agreements, and technical operational safety and reliability considerations. Careful consideration by sponsors, lenders, investors and other market participants of these factors at an early stage of BESS project development are necessary ensure the ultimate success of the project.

1 According to March data from Chilean renewables and storage association Acera, 364MW of battery storage capacity is operating, while 240MW is in the testing phase, 1.05 GW is under construction, 2.23GW has an environmental license and 6.23GW is in the environmental review phase (See "Chile US$350mn standalone battery storage system submitted for review," April 19, 2024, BNAmericas).