The Long Term Service Agreement (LTSA)* is a dense, complex arrangement that can last for many years. While considerable value can be created through these relationships, significant risks also exist. Due to the long tenor of these contracts, these risks are also likely to change and evolve over time. Value that seemed promised at the beginning of an LTSA may be irrevocably lost as the contract matures, falling out of step with the changing realities of the market and operations.

Unfortunately, it is extremely difficult to reopen an LTSA contract in order to recapture that value. Such efforts are often hampered by opposing incentives and considerable friction between the owner and service provider. Rather, power asset owners must take a more proactive approach up-front, during the initial negotiations, to ensure that the value from the LTSA is maximized even under shifting market conditions.

This Trimountaine Group white paper draws upon our team's experience in negotiating LTSAs on over 300 turbines around the globe and over the course of the last decade. Despite increasing sophistication in the legal structuring of these contracts, we still find that most LTSAs fail to fully deliver upon the value promised during negotiations. In many cases this is because the LTSA has failed to adapt to the changing market and operational conditions of the turbine.

Most LTSAs fail to fully deliver upon the value promised during negotiations

Below are three key areas where sophisticated asset owners can better adapt their LTSA negotiations to account for this risk dynamic.

Turbine Life Cycle

The following chart shows the typical life cycle for a gas turbine. As the turbine is first introduced to the market, the OEM tends to have a monopolistic control over critical parts and service for the turbine. Over time, that advantage erodes as competitors respond with their own offerings.

Gas Turbine Maturity Life Cycle Chart

As competition enters the market, two things occur. First, the new competitive pressure tends to drive down (or at least stabilize) prices for parts and services. Our data suggests that the introduction of even just one competitor will compress prices by as much as 14%.

The introduction of even just one competitor will compress prices by as much as 14%

Second, competitors often seek competitive advantages by improving upon the initial design or maintenance process for the turbine. This can lead to extended life cycles for critical components, lower maintenance costs or better operating conditions.

The introduction of 3D printing into the manufacturing process, for instance, will further accelerate this parts maturity cycle. While 3D printing for turbine parts has been relegated to non-critical components, so far, it is likely that the technology will soon enable life limited components to be created. This new process could radically change the turbine refurbishment market.

For one thing, it is likely that third party providers will be able to introduce new parts to the market far more rapidly than before. By printing in 3D new parts providers will not have to invest the same time and money into creating a new manufacturing process. New designs could, theoretically, be shipped within days of initial concept. Whereas OEMs of yesterday's advanced turbines could reasonably enjoy 15-20 years before serious competition matured in a new market, tomorrow's competition could be up and running within a few months.

3D printing will radically change the performance of life limited components as well. 3D printed turbine blades, for instance, may be able to maximize cooling flows in ways that were unachievable in traditionally manufactured blades. These new blades could be left in longer and operate at higher temperatures, all while being manufactured at a lower price than today's components.

This has dramatic implications on how an LTSA should be negotiated. A contract without the right amount of flexibility could end up destroying significant value by not allowing the owner to participate in these changing market dynamics. For instance, pricing models that are based on the assumption that the OEM will retain price advantages throughout the life of the contract should be reconsidered. Escalation clauses should be carefully looked at to ensure that LTSA costs don't begin to deviate from market conditions once new competition enters. And off ramp options may be appropriate to insert into the contract after every few inspections in order to ensure the asset owner has a mechanism to reopen the contract amid changing market conditions.

Escalation Clauses

In particular reference to escalation, we find that this clause is one of the largest sources of lost value for asset owners.

The typical escalation clause will be a weighted combination of a few publicly available indices. These indices often reflect a general market basket of turbine goods and services and, in theory, correspond to the increasing costs to the maintenance provider over the life of the contract.

Unfortunately, this isn't always the case. While the initial framing of the escalation clause often does represent the costs to the service provider, over time the calculation begins to deviate from reality. Exacerbating this can be the inclusion of collars and floors on the escalators that unfairly accelerate costs to the owner.

Consider the following chart. Here is a graph of the Producer Price Index (PPI) for Turbines and Turbine Generator Sets obtained from the Bureau of Labor Statistics (BLS). This index is then compared to a typical LTSA escalation provision over the course of the last 15 years. In this example, the LTSA escalator uses the same PPI index but with the addition of a minimum yearly escalation of at least 2%.

Example Deviation Caused by an Escalator Clause Floor

The deviation that occurs is solely driven by the artificial floor created by that 2% minimum. Instead of correcting itself during adverse market conditions, the LTSA continues to march inexorably upward in cost. By the time the term is completed, in this simple example, the project owner would be paying 12% more.

However, even if such floors are removed, the asset owner may find themselves with significant volatility to their monthly payments. This works against what, to many, is a fundamental benefit of entering into the LTSA in the first place: the consistent payment streams.

Fortunately, financial tools exist to help owners hedge this volatility. Cost Escalation Insurance, for instance, can be purchased against the contract's indices, even over the entire term of the LTSA. This essentially caps the escalation experienced by the asset owner and is a valuable tool in an owner's negotiation toolbox.

Changing Operating Regimes

The initial expectations as to how often and when the turbine will be operating are likely to change. Even as we examine the last decade or so in the natural gas power market we can see the whipsaw effect in the dispatching of these assets. Projects built under the assumption of being baseload facilities witnessed an overbuild of new gas power capacity. These assets then switched to cycling or peaking duty to compensate. And then coal began to be chased out of the market, shale gas flooded in, and wind power began to take off.

Understanding how the turbine will operate in ten years requires a very specific kind of crystal ball

The use of a Power Purchase Agreement (PPA) will offset this operating risk to a degree. However, even here there is open exposure to the asset owner. Of primary importance is in matching the differing lengths of the two contracts.

This is often complicated by the fact that an LTSA may have a term based on the completion of certain inspections, whereas the PPA may be more calendar based. While, financially, a take-or-pay agreement provides revenue certainty to the asset owner, it does not necessitate actual turbine usage. As such, the turbine may not reach its projected maintenance intervals on the same cycle as the PPA, leading to a disconnect between the two contracts and expensive costs to the owner.

To protect value, owners should consider the following during the contractual negotiations:

• Term Definition: How is the term of the LTSA clarified? By date or outage type? What openers exist and at what intervals in case the LTSA deviates from the market?
• Payment Considerations: How are the fixed payments and extraneous payments determined? If the operating regime changes, what impact does this have on the payment stream and on the repair work being done? Is there more risk in a higher fixed payment or in higher inspection related costs?
• True Up Clause: How does the True Up Clause calculate under different scenarios? Is the owner unfairly paying for maintenance or parts life that has not occurred?
• Parts Title: Who owns the right to the parts and remaining life at the end of the term? Who has parts title when the parts are removed for life limitations? How does the value of the parts change under different operating regimes?