Energy Risks & The PPA As A Tool For Risk Allocation
Sharing some key insights on risks, terminology, and definitions.
PPA's are complicated...
They're highly negotiated contracts because both parties have to clarify and agree on the allocation of many different energy risk factors. To learn more about PPAs I attended the PPA Academy hosted by the Swiss Fintech company called Pexapark. In this post, I am sharing some of the key insights that I gained.
PPAs are not new, however, few have had any reason to learn the ins and outs of such a complicated contract. This appears to be changing quickly. In many countries, government subsidies are winding down and so the solar power industry is transitioning away from a subsidized-regime towards a market-based regime.
In this article, we want to educate you on the existing risks: What is the terminology and how are they defined?
When two parties enter a PPA negotiation several pressing questions need to be answered in order to make the PPA negotiation successful. What are the risks? How are the risks defined? Which party is better suited to accept each risk and are there strategies that both sides can collaborate on in order to lower the total risk profile of the contract?
Each party is liable for the volume of MWhs the producer has to deliver and the offer to accept.
Changes in the legal framework that PPAs are built on are a potential threat. The same is true for any regulatory changes in the operation of solar assets. Regulatory risk can range from negligible to severe, depending on which market the PPA is formed.
Whenever entering any contract there is a risk of litigation in case of non-fulfillment of the contract.
How much will it cost either party if the PPA fails for any reason? The answer to this question is replacement risk quantified in €.
Settlement Risk exists in any business transaction. Here it describes, how much power has been delivered, but has not yet been paid for?
Forecasted production can often be incorrect. An imbalance between realised power and planned power production has to be absorbed somewhere.
If too much power is produced at the same time in the same geographic region the price will collapse due to oversupply.
Solar assets produce power in cycles that follow the sun cycle (day/night) and of course seasonal changes (ie. more power in the summer).
Any long term business transaction bears the risk that either party can become illiquid and will not be able to fulfill contractual obligations because of it. Since the PPA is descriptive of the revenue with which a solar asset can be financed, lending banks tend to set pretty high standards, as to who is an acceptable off-taker and who is not.
If power prices change drastically an off-taker may be overpaying as compared to daily spot prices, or vice versa. Same for the producer, if prices skyrocket, she is losing out on potential profits.
Five risks are marked in bold because they are, in my opinion, the most pertinent risks specific to solar PPAs. We will discuss price, volume, replacement, imbalance, and profile risk in more detail.
The 5 Major Risks
Different than fuel-burning power plants, solar power plants can’t really produce a steady baseload. The weather, seasonality, and other geographic influences are always present in the daily operations and influence power output.
PPA's are typically long-dated contracts running 10-15 years. In the PPA the power producer will agree to deliver a fixed volume of MWhs to the off-taker. It is possible that the producer will find themselves unable to accomplish the forecasted amount. In that case, they would have to purchase the missing amount somewhere else and deliver it to the off-taker.
In the case of overproduction, the excess volume also has to be dealt with. On the other side, the offtake has a similar risk. They agreed to accept a fixed volume of MWh's. If the consumption falls short the off-taker has to figure out what to do with the excess power.
The failure and subsequent replacement of a PPA costs time and money. The producer loses a fixed revenue stream, often the only revenue for a single asset. Since entering a PPA is somewhat complicated, there is a significant cost associated with having to replace an off-taker. Finding an interested party and negotiating a new agreement takes usually 6-9 months.
Power prices may have changed and interim solutions for selling power on the spot market will have to be arranged. An off-taker losing access to the power of a producer is almost equally as painful. Industrial off-takers may have made estimates of production costs and margins calculated with a fixed power price in mind.
When a PPA fails, there will be volatility in the purchase price of the amount of power that has to be replaced. In addition, the same obstacles to entering a new PPA apply as for the producer. All these potential losses and costs are lumped together under the term replacement risk.
A power producer makes a large and reasonable effort to forecast the amount of power each of its assets will produce. However, as with any forecast, they can be more or less accurate. If any amount other than the forecasted amount is delivered to the transmission system operator (TSO), there will be an imbalance. TSO's are equipped to manage these imbalances, this is part of their business model and of course charge a fee for both, under- or over-delivery. The costs associated with this are called imbalance risk.
Solar assets, obviously, produce power when exposed to sunlight. Therefore, the power output of a solar asset depends on many factors, including the physical design and orientation of the modules. In addition, there are naturally changing day and night cycles, changing the number of sunlight hours per season, etc to contend with.
All this leads to an ever-changing power profile that the asset can produce. Simply put, how do we come to terms with the fact that an offtake will most likely require power 24/7 but the producer can only provide power during the day? This has to be clarified and mitigated when negotiating a PPA.
Currently, the trend is going away from producer friendly Pay-as-Produced PPA's. This means that producers have to come up with a strategy on how to manage the profile risk of their assets.
Graphic courtesy of Pexapark's LinkedIn Post
One of the most highly negotiated parts of the PPA is the price per MWh that an off-taker will pay for the power the producer is generating. A PPA is a long term commitment, usually lasting 10+ years. The electricity market is considered one of the most volatile markets on the planet. It is easily possible that the price of a MWh increases significantly over time.
This means, of course, that the producer is losing out on potential revenues that the same asset could have produced without the PPA or with a different price finding agreement in the PPA. The same is true on the other side of the deal. An off-taker locks in a rate that is typically favorable as compared to market conditions at the time of signing. But these market conditions can of course change. The off-taker has to accept the risk that they may end up overpaying in case of dramatic price decay in the market.
If you have read this far, you have now gained a first impression of what kind of negotiations you will have to lead when entering a PPA. Please don’t be discouraged, for each risk, there is a mitigation strategy. Often risks can be minimized right off the bat based on the selection of a potential PPA partner.
Some partners are better equipped to handle certain risks than others. Even beyond that, there are many instruments and strategies that help alleviate various pitfalls. Pexapark is an expert firm and can advise you on all of the above and beyond. I highly recommend you connect with them if you have more questions or are in need of a PPA solution.
I hope you find this quick look and definition of the risks associated with entering a PPA helpful. This is a rapidly evolving field and I find it very encouraging that market-based solar assets are becoming the new normal. It is uncomfortable at first, but a mandatory change in the process of solar power becoming the #1 electricity source in the world!