Power Purchase Agreements for financing and buying renewable energy

Creative marketers of electricity keep searching for innovative concepts that help them increase sales. The acronym PPA (or Power Purchase Agreement) seems to be such a concept at this moment as our clients are bombarded with PPA proposals, often presented as super solutions.

In the following blog article, we will focus on two aspects of PPAs:

• Power Purchase Agreements to finance renewable energy: a long-term bilateral agreement to sell the electricity output to an end consumer or a supplier that will sell the electricity to end consumers.
• Power Purchase Agreements for consumers: the signature of an agreement directly with a producer of renewable energy without the intervention of a traditional electricity supplier.

What makes Power Purchase Agreements interesting?

End users are interested in PPAs for two reasons. First of all because they are a great tool to comply with renewable energy commitments. It’s stronger than the standard method of buying guarantees of origin because you can really show that you buy electricity from a specific asset. And signing a PPA shows the company’s commitment to develop renewable energy.

Secondly, PPA’s can lead to cost savings. In some cases, the PPA allows you to buy electricity at a lower cost than the electricity that you would buy from the grid. This arrangement can come in two ways:

1. A discount on market prices. The question is of course, what market price, spot prices or forward, and if forward which of the products. A variation on this can be found in Latin-America where PPA’s are sold with a reduction on the regulated market tariff.
2. A fixed electricity price.

Which set-up is the best for you depends on your risk profile. For market risk clients, whose primary concern is to have a price that is never high above that of their competitors the “discount on market prices or tariff” is the best solution. For a budget risk client that wants to avoid unexpected increases in cost, the fix price arrangement is the preferred choice.

Of course, we can ask two questions here: 

1. Will the fix price arrangement survive the volatile energy markets? Will markets not drop below levels at which the long-term price was set?
2. Why on earth would a producer sell below the price he can get in the market?

On-site versus off-site production

For both questions we need to look at the regulatory context and more specifically explore whether a saving can be made on the regulated part of the electricity bill, the grid fees and taxes. This depends on whether your produce on-site or off-site:

• On-site production, e.g. rooftop solar installed on your facilities by a third party. In this case, it is to be investigated whether you need to make capacity payments on the electricity that you consume on-site. Spain, for example, should be a paradise for on-site PPA’s, but the capacity payments on on-site consumption completely kill the potential.
• Off-site production, e.g. you buy electricity from a windmill park in the vicinity. In some countries, such as Brazil, you can get a discount on grid fees if you buy green electricity. This is a government incentive for renewable energy, and a smart one.

In case of a positive situation, a PPA can be made that creates a real win-win situation for both seller and supplier. Let’s say that grid electricity costs 50 euro per MWh for the commodity only and 100 euro per MWh total costs, including grid fees and taxes. If you then make a price arrangement at 75 euro per MWh or commodity price (wholesale reference) x 1,5, then both sides of the deal win. The buyer has electricity at a lower cost than buying it from the grid. The seller makes more money for the electricity than in the case that he sells it to the grid.

PPA’s offer investors what subsidies used to: security

Producers in renewable energy seem to have developed a huge interest in selling their output through PPAs. They tell us that they need the PPA to get their financing. Investors and borrowers are apparently not satisfied with the engagement to sell the electricity in the mainstream power market and prefer the long-term engagements of PPAs.

Therefore, in some countries where the pure win-win based on avoidance of grid fees and taxes is not possible due to the regulatory situation, we see that producers of renewable energy are signing PPAs with prices below the price that they could get at that moment in the open market. We believe that this is absurd and based on a financing environment that is too focused on stable streams of money.

For a long time, renewable energy was completely financed with subsidies. That was an environment of fixed figures. The investment cost is well-known and in many cases the subsidy or minimum income in case of certificates systems was also known. Investors and creditors made their analysis based on the rate of return guaranteed by the subsidies. A project developer told me in those days of generous subsidies that the financial world just wasn’t interested in what you did with the sales of the electricity itself, they just looked at the fixed figures of the subsidies.

These days, most countries have turned down the subsidies, some of them even all the way down to zero. Fortunately, the declining investment costs have made subsidies unnecessary. Thanks to grid parity, the income of selling the electricity itself is in more and more cases sufficient to win back your investment.

The dangers of the PPA frenzy

Hence, this sudden interest in PPA’s as project developers look for a long-term supply agreement to convince investors and banks. And in their hunger to have that PPA, they accept discounts on what you can get in the wholesale market.

I have a whole series of remarks to that, these are the most important ones:

1. My most basic commercial instincts make it impossible for me to accept a deal below current wholesale market conditions as a good deal. Signing with an end consumer means that you take on extra risks regarding volume and payment that you don’t have if you sell the electricity in the wholesale market. Why would I take those extra risks and give the other side a discount?
2. It’s overly simplistic to prefer the simplicity of fixed numbers to the more advanced reasoning of developing a good market trading strategy.
3. In case of increasing wholesale electricity prices, these PPA’s will result in a massive hangover for the renewable energy sector.
4. As a buyer of a PPA, you will see that the advantage versus buying from the grid is not very large. Are you willing to take the risk of a declining market that means your PPA power becomes more expensive then what you buy from the grid? If your primary or only motivation is sustainability, you could live with that. But if you’re after the savings, a PPA with a fixed price a few euros below the current price of buying electricity from the grid is simply a deal that is too risky.
5. More and more electricity is produced from renewable sources. For the functioning of our electricity markets, it’s a pity that this energy is withdrawn from the normal market and locked up in a bilateral circuit of PPA deals. If renewable energy is traded and hedged in the regular wholesale markets (OTC or exchanges), this could create more liquidity on futures that are many calendar years away from here and on options. This increased long-term liquidity would create much needed extra hedging possibilities for end consumers, particularly the budget risk clients in search of stable energy costs.

We have helped renewable energy project developers to set up and implement solid strategies with layered buying of futures and / or options in the wholesale markets that make sure that a minimum return on the investment is protected without blocking the opportunities of increasing markets. Let’s hope that the PPA frenzy doesn’t destroy the willingness of the financial world to accept such good trading practice.

How to validate a PPA?

For the buyers of PPAs, we have three big recommendations:

1. Explore the regulatory context. Make sure you know how much money the seller can make and don’t be blinded by win-win talk.
2. Are you harvesting the low hanging fruits by negotiating PPAs in places where the costs and regulatory context make them most interesting?
3. Organize a competitive PPA tender. All too often we see that the first one that walks in to propose a PPA gets the deal. And that Power Purchase Agreement tenders lead to remarkably better results, both in terms of pricing and other conditions.

Renewable energy has reached the historic point of grid parity in many countries. This opens up new opportunities of buying electricity at structurally cheaper prices. But think beyond the PPA buzzword rhetoric to create real long-term value for your company, whether you are on the selling or on the buying side.