5 Principles for
PPA Risk Management

2
Featured

5 Principles for
PPA Risk Management

5 Principles for PPA Risk Management

Power Purchase Agreements (PPAs) are the most common way to fund renewable energy projects, and are used for rooftop and utility-scale projects alike. Through a PPA, the Buyer (the “Offtaker”), typically makes no upfront investment in the project, and instead makes service payments ($/MWh) for the power produced by the project over the term of the agreement.

Off-Site PPAs are the industry-leading tool for Corporate Buyers to purchase large volumes of high-quality RECs (learn about RECs). Through an Off-Site PPA, the Buyer enters into a bilateral agreement with a large-scale solar or wind farm, often located far from its facilities, and commits to a certain PPA Price ($/MWh) for the power generated by the project. This price commitment provides a reliable revenue stream, enabling the Developer to raise non-recourse debt and finance the project affordably. In exchange for its commitment, the Buyer takes ownership of the energy attributes (the “RECs”) that are created to reduce its Scope 2 emissions.

In many cases, these Off-Site PPAs are financially-settled (a “Virtual PPA”), meaning that the power is not physically delivered to the Offtaker. Instead, the power is sold into the electricity spot market where the project is located, typically in exchange for a floating energy price that fluctuates hourly based on supply and demand. The VPPA is financially-settled as a contract-for-differences (CfD), where the Corporate Offtaker makes or receives settlement payments each period (often monthly) – depending on the relationship between the PPA Price and the Floating Market Price during times of production (Exhibit 1).

For example, if a Buyer agrees to a $40/MWh PPA Price for capacity on a project that produces 10,000 MWh in a given month, and sells that power into the spot market at a volume-weighted price of $50/MWh – the Buyer would receive a positive settlement of $100,000 for that month. Inversely, if the hourly market price fell to $30/MWh throughout that month, the Buyer would make a $100,000 payment to the project.

Exhibit 1

Financial settlements are calculated as the difference between floating market prices and the negotiated PPA price, multiplied by the quantity of generation during each period.
article-image1

Multiple factors including rising interest rates and surging demand have caused PPA prices to increase considerably since 2019. Due to the settlement characteristics of the PPA, and the consequential relationship between PPA Prices and Market Prices in determining cash flows, rising PPA Prices result in greater financial risk for Corporate Buyers. In this environment, while PPAs remain an effective tool, it has never been more important for Buyers to take steps to mitigate the risk associated with Virtual PPAs.

share

PPA Risk Mitigation

Here are 5 Principles for Risk Management that all Buyers
should consider when pursuing PPAs:

Location Selection

Off-Site PPAs should be perceived as a mechanism to 1) procure high-quality RECs, and 2) hedge against energy market volatility. PPAs should not be viewed as a profit-center, but there can be significant financial benefits in the form of long-term price stability.

Through this lens, the most cost-effective strategy for PPA risk mitigation is to select projects that are financially-settled in the same market where your company buys its electricity. As a result of doing so, any rise or fall in energy prices in that market, which increases or reduces the operating costs at your facilities, will be offset by the PPA settlements that move in the inverse direction – thereby stabilizing your energy costs.

By siting your PPAs strategically, these contracts can be transformed from a speculative financial instrument with inherent risk, into an effective tool for stabilizing energy costs while meeting ESG goals.

article-image2
Image: U.S. Electricity Markets

Portfolio Diversification

As with any “investment,” diversification within your portfolio is a fundamental aspect of risk management. Rather than “putting all your eggs in one basket,” Buyers should explore opportunities to transact across multiple technologies and markets, to diversify risk exposure.

In its simplest form, diversification of technology may include PPAs for both solar and wind projects, as these technologies have different seasonal and intraday production profiles. Solar PPAs will provide outsized market exposure to prices during summer and daytime hours, while wind projects tend to generate less during these periods. Similarly, geographic diversification across settlement locations can limit your exposure to the supply and demand fundamentals in any single market.

The feasibility of diversification may vary based on your size and operational footprint, however Buyers should consider opportunities for diversification when building their strategy.

Strategic Sourcing

There are many capable Developers that are actively searching for land, securing interconnection queue positions, and seeking Offtakers to help make their projects a reality. Buyers should engage broadly with Developers of various types and sizes to increase the surface area of their procurement.

While Buyers should review offers from large and well-capitalized developers, it can be rewarding to keep your options open. For example, rising interest rates and lengthening interconnection approvals have put pressure on smaller Developers, which may not have the resources or desire to complete certain projects. Buyers may find opportunistic situations like this, where a partner like PerpetualGrid can arrange for the acquisition and completion of such projects, enabling access to PPAs at more competitive rates.

By engaging with a diverse network of Developers and reviewing many potential offers, Buyers can find unique opportunities and gain confidence that they’ve selected the best deal possible.

Downside Protections

Virtual PPA financial risk is primarily driven by the potential for negative settlements, occurring when hourly market prices fall below the PPA price. To mitigate this risk, Buyers may negotiate non-standard settlement structures, underpinned by options contracts, that limit downside price exposure.

The most common example is the $0/MWh Price Floor, where the Buyer pays a premium to ensure the market priced used to calculate settlement payments doesn’t fall below $0/MWh. Alternatively, the Price Collar often features a higher Price Floor and the addition of a Price Cap, which limits the upside for a Buyer beyond a certain price – transferring the incremental profits to the Developer, in exchange for a reduced price premium on the higher Price Floor (Exhibit 2).

The availability and price of such insurance policies can vary, however risk-averse Buyers should explore their options and determine whether these protections are worth the premium.

Exhibit 2

Buyer's may negotiate non-standard commercial structures to limit the downside risk exposure of VPPAs, effectively capping losses if market prices trend lower than the strike price.
article-image3

Equity Investments

The contract-for-differences structure of a Virtual PPA can be understood as a mechanism for “renting” capacity on a project – with no potential for a return on investment. As rising PPA prices increase the risk of negative settlements, Buyers are beginning to explore the feasibility of equity investments in their projects to improve the reliability of the economics.

Leveraging non-recourse debt and increased tax benefits from the Inflation Reduction Act, Corporate investors in renewables can expect attractive risk-adjusted returns. With support from flexible partners like PerpetualGrid, Buyers may pursue greenfield projects or the acquisition of an existing project under development – enabling them to avoid offtaker competition and become a long-term owner an asset that will generate revenue (and RECs) for decades to come.

While the feasibility of an investment depends on factors including the availability of capital, Buyers should consider an investment as an opportunity generate a more reliable ROI.

Renewable Energy PPA Advisory

PerpetualGrid specializes in the strategic planning and implementation of PPAs, with an emphasis on risk mitigation and financial returns. Our team has advised some of the largest and most advanced Corporate Buyers in the world, helping them evaluate and execute on PPA transactions and investments.

Interested in learning more and exploring solutions for your organization? Schedule a consultation with our team.