New Energy Solar and Renewable PPA Agreements

A power purchase agreement (PPA) is a contractual agreement between an energy buyer (off taker) and seller to buy and sell energy generated by a renewable asset (solar or wind power). The PPA regulates the terms of the sale and purchase of the power and PPA’s vary in terms of volume, structure and pricing tailored to a particular project. Understanding the specialist terminology in the sector is a key to understanding the risks associated with entering into a PPA.

1. The commercial structure

The key risk is for the offtaker (the buyer of the power) is the price and then how risk is allocated between a Seller and Buyer? There are a number of cost models such as Baseload, annual Baseload, monthly Pay-as-produced, no volume cap, Fixed Price for Fixed volume, to consider.

2. Principal risks allocated between Seller and Buyer?

The risks include Price Risk, Liquidity Risk, Volume Risk and Profile Risk.

3. Matters to consider:

• The duration of any fixed price element?
• How is the start date defined?
• Consequences of a delay to the agreed start date.
• Is there a fixed date, or a grace & delay period.
• What are the grace period penalties?
• The conditions precedent to fixing the price? Is there a defined reference price? Is a closing in tranches possible?
• Can the PPA be assigned to another off taker (is Seller approval required)?
• What protection exists against credit deterioration of the buyer? Is there a Bank Guarantee, or security interest.
• What contract adjustment rights exist? what If negative prices occur?
• Consider Legal, market and regulatory changes.
• How is availability of energy guaranteed in terms of minimal volumes?

You also need to consider and carefully review the exit and termination rights such as:

1. Non-payment of invoices for certain period.
2. Non-availability of supply beyond certain thresholds.
3. Non-performance of minimum guaranteed volumes for certain periods.
4. Delay of the Commercial Operation Date (COD) a key date of operation .
5. Adjustment or variations due to legal requirements .
6. Triggers that could lead to contract termination?
7. On what basis is the termination amount (“Close out Amount”) determined or pre-determined?

4. Settlement

Is settlement physical or financial?  If financial prefer a Virtual PPA which have gained in popularity across Europe.

5. Commercial structure

The commercial structure is one of the top factors that will define the risk allocation of a PPA as momentum around Baseload PPA’s increases.

6. Balancing Risk

There will always be a supply risk as a  plant has production commitments not only to the seller but to the system operator as well. So, if the buyer doesn’t receive the expected production volume, the energy needs to be acquired elsewhere. On the other hand, when the plant deviates from what the grid expects production volume to be, there are imbalance costs for the project charged by the system operator.

The magnitude of that imbalance cost is driven by the actual deviations between scheduled production and real production (“forecast error”), the regulatory design of the balancing market (i.e., punitive design with penalties) and finally, whether portfolio effects may exist.  The seller usually has a balancing agreement with a third party for a fee, as a mitigation tool.

Summary

These are just some of the issues that need to be considered on both sides. To better understand the terms of the PPA , you do need to understand the sector “lingo” and ensure you seek appropriate Specialist legal advice.

Annual Baseload PPA –This is a volume/contract structure. In an annual baseload PPA, the buyer agrees to buy a pre-determined volume of energy for every hour over the year. Profile and volume risks sit with the seller here, because they have to deliver the agreed energy no matter what. If there’s low production and the seller cannot meet its obligations through its plant, the volume may need to be sourced from the spot market.

Buyer / off taker / purchaser- This is the entity purchasing power from a renewables generator which could be a corporate, a trader or a utility, also known as off-taker, consumer, or purchaser.

Capture Factor  –This represents the ratio of captured price over baseload price. For solar, typically capture factors are around 1 in winter and slightly lower in summer when most of the production occurs. For wind, they tend to be lower in winter, where production predominantly occurs.

Cannibalization risk –The risk of falling renewables revenues due to reduced price following high market growth of renewables assets. When large volumes of solar PV are produced simultaneously, the capture price in the system during production time will decrease as other, more expensive technologies will not be needed to produce electricity and therefore not set the price in the market.

Contracted volumes  –Renewable production volumes committed for delivery within a PPA agreement. Depending on a buyer’s needs, they may want to contract the entire volume (100%) or part of it (i.e., 50%).

Contracts for Difference (CfD) –In a CfD, two parties enter an agreement to trade a financial instrument. In the renewables world a financial instrument is electricity. CfD mechanisms have been widely used as a government support mechanism, where projects participate in an auction and bid for a strike price. Under a CfD mechanism, the project sells its energy to the wholesale spot markets. Depending on movement in the spot prices, there are cashflow exchanges between the generator and the other party, which is usually a government entity.  If the market price the generator sells its energy at, also known as reference price, is above the strike price agreed, the generator will pay back the difference. If the reference price is below the strike price, then the buyer will pay back the difference.   Besides acting as a government subsidy instrument for renewables a CfD can be agreed in bilateral PPAs and in Virtual PPAs.

Corporate –A non-utility, non-trader consumer of electricity. Industrials are often referred to as corporates, but the difference is that industrials’ energy needs are significant, and energy costs are directly linked to the cost of production.

Degradation –Refers to the depreciation rate of producing solar in each year which is the rate at which photovoltaic panels degrade over time. Production volumes might have a 2% pa degradation rate applied which means that every year the solar panels output 2% less electricity than the year before.

Energy Yield Assessment –  It’s the technical assessment of the expected annual energy yield of a planned power plant carried out by an engineering firm and plays a crucial role in the volume a plant can commit to selling.

ESG factors  –The acronym stands for environmental, social and governance being non-financial factors to identify a company´s sustainability and societal impact. ESG focus, for instance on funds that invest in carbon-neutral companies, some special bonds (called ‘green bonds’) were issued specifically to finance green projects. Financial data vendors have also developed benchmarks and indicators to track the ESG performance of individual companies.

Exposure –A power plant is exposed to the volatility of wholesale electricity markets. known as merchant exposure, depends on how much volume it has contracted under fixed-price instruments. If a generator expects an annual output of 10GWhm and has contracted 6GWh through a corporate PPA, its exposure is 4GWh. Exposure is also known as revenue risk.

Feed-in tariffs (FITs) –FiTs are subsidy schemes whereby a fixed amount, independent of the wholesale market price, is paid for the electricity produced from renewable energy sources and fed into the grid at any time. FITs are long-term contracts awarded to renewable energy producers as a way to encourage the buildout of renewable energy installations. In mature markets, FiTs have been replaced with competitive auction schemes.

Financial PPA-Another common term used for a Virtual PPA. It is treated as a financial instrument, often based on the International Swaps and Derivatives Association (ISDA) contract. The agreement doesn’t deal with the physical electricity delivery of electricity but typically includes the Guarantees of Origin. It’s a common structure in the US, but not very advanced in Europe as it is considered a derivative with a different accounting treatment under the International Financial Reporting Standards (IFRS) than a physical PPA.

Forecast inaccuracy –The difference between forecasted, on a day-ahead basis, and actual realised production of a plant.

GoO  (Guarantees of Origin)-Guarantees of Origin are an instrument defined in European legislation that labels electricity from renewable sources to provide information to electricity customers on their energy source. In many cases, GoOs are used as property rights to transfer the “green benefit” of renewable electricity production from the seller to the buyer.

Hedging and Hedging ratio-Hedging is a process to reduce price risk, against price uncertainty, by taking an offsetting position of approximately the same size but opposite price direction. Hedging shows how exposed one is to energy risks.  In a PPA, it’s common for a producer to hedge 70% of the production. In trading lingo, it’s the comparative value of an open position’s hedge to the overall position.

LCOE –Levelized cost of energy (LCOE) is the average net present cost of electricity for a generating plant over its lifetime. It’s used as a comparative cost value for different energy technologies, and their investment attractiveness.

Liquidity –A core concept in financial trading, which includes trading of energy. The market price is made up of bids and offers for certain levels of volume arranged in a stack. If there are not enough offers on the market, one may not be able to transact at the desired price or at all. Liquidity is fostered by the market, the number of market participants, their risk appetite and market regulation. Ideally, the market has enough liquidity, so that electricity or natural gas can be sold and bought with reasonable transaction costs, and without small trade volumes impacting the price of the commodities.

Liquidity Shortfall –The risk that the non-contracted volume has a negative value which may occur due to un-favourable weather conditions (causing volume shortfall) and/or due to un-favourable spot price distributions.

Market Access PPA –A market access contract, also known as direct marketing, is for the sale of electricity at market prices. It’s provided by utilities or traders for generators. It covers services such as forecasting production, imbalance management and trading to wholesale markets. A market access PPA does not provide fixed revenue to generators.

Mark to market (MtM) –It is the concept of reconciling the value of a futures contract with current market pricing. It’s the Net Present Value (NPV) under current market prices vs prices as of the day of contracting. MtM is essential in knowing the value of a position and understanding how much it costs to unwind a position. It is also an indicator of performance vs the market.

Merchant power plants  –When a renewable energy plant is exposed to normalised power markets with no publicly guaranteed long-term renumeration. The term ‘merchant’ is also referred to as subsidy-free renewables. A merchant plant would receive the fluctuating daily spot market price, instead of a fixed-one. Merchant plants reduce merchant exposure through hedging instruments, such as PPAs.

Monthly Baseload PPA-In this commercial structure, the buyer agrees to pay a pre-agreed amount of electricity for every hour of each month. This way, the seller is taking into consideration the seasonal variability of production. The difference between the produced volume and the contracted volume is settled at the spot market.

Monthly Profile Cost/Gain-The difference between the value of a monthly profile (volume-weighted average of monthly prices) and an annual baseload profile (flat average of the prices). Whether the difference is a cost, or a gain depends on the correlation between the monthly volumes and the monthly prices.

Off taker  –In a PPA is the party that buys the energy, also known as the buyer. It’s the purchaser who buys power from a project developer without taking ownership of the plant.

P-Values (e.g., P50/P90/P10) –Percentiles are a universal statistical concept used to identify the percentage of scores that falls under a specific value. In the PPA world, probability figures are commonly used to calculate an asset’s production volume, and therefore the revenues from the sales. Before the investment decision, an investor needs to ensure the plant’s profitability based on its output, before moving to assess how other risks influence the plant’s revenues. During the energy yield assessment, there’s a forecasted annual production. The P50 figure represents a 50% chance for the actual output to exceed the forecasted production.  The P90 figure represents the volume that it’s 90% probable to be the actual production. Typically, the P90 figure is the smallest one, as it’s the more conservative one. Lenders commonly use it to be on the safe side.  P-Values are used in many distribution assessments, such as revenue, price, cost savings and other.

Pay-as-produced (PAP) –PAP is the most widely known volume structure. In this structure, the off taker buys any volume produced from the asset at any time. It is similar to a prototypical feed-in-tariff.

PCG –A parent company guarantee (PCG) isa form of credit support to shield the counterparty from losses from failure to perform contractual obligations. It can be provided to any party of the contract.  If the off taker has a low credit rating – or no credit rating at all – the investment-grade parent company may need to act as guarantor. Lenders usually make it a requirement for a loan agreement.   Likewise, an off taker may ask for a guarantee from a project developer to mitigate the risks of a project not moving forward after signing the PPA.  Other examples of credit risk mitigation tools include bank guarantees or cash into an escrow account.

Peak load PPA –This is one of the many PPA volume/contract structures, although not a common one It represents a structure where the agreement is around the peak hours of consumption from Monday to Friday. All-day is typically from 8am to 8pm.  So, the buyer only commits to buying energy for their consumption during these hours. There are different blocks to pick from, such as off-peak – i.e., purchase power for night load only.

Physical PPA-A physical PPA contract, also known as sleeved PPA, is a contractual agreement where the asset and the off taker are in the same grid network. This means that there is a physical transfer of the energy – contrary to a virtual PPA. A third party such as a utility is appointed to manage the electricity delivery on behalf of the project. This implies that the physical aspects, such as balancing, need to be included in the contract.

Price risk- In the PPA price risk is the uncertainty of not knowing what price you will get for the energy you produce. For the off taker, it’s the uncertainty of not knowing at what price you will buy energy. The uncertainty (e.g., probability of loss) stems from the high volatility in the wholesale market prices. Price risk is unavoidable but can be mitigated through hedging instruments, such as a PPA or a futures contract that will fix your price.

Profile risk- Profile risk arises from the fluctuating nature of renewable energy (for example, no solar energy is produced at night). In markets with high renewable energy penetration, times of high production can mean a significant decrease in power price(revenue) depending on the location and type of the plant (solar or wind). You can mitigate this risk by choosing certain PPA structures. Electricity prices are usually quoted for standard products that are based on 24/7 baseload deliveries of electricity.  The “profile risk” of a generating asset such as a wind farm is where the hourly production profile deviates from the baseload characteristic and corresponding hourly prices lead to an overall lower value (or higher, as the case may be) in aggregate. The magnitude of the profile risk is driven by the actual profile of the generating asset, the correlation between the generating asset’s forecast error and market prices and the structure of the overall generation market. In markets with high penetration of renewable energy, there is generally a negative correlation between times with lots of wind and/or radiation and market prices. This is often referred to as “cannibalization” effect and forms part of the profile cost. Profile risk can only be hedged through “fixed price” products where a utility is willing to pay a fixed price (usually at discount to the baseload price) for the entirety or parts of the volume produced by the wind farm during at any time. Profile risk captures short-term variations of production, even if the annual production is in line with forecasted volumes.

Regulatory risk  –It’s a risk stemming from regulatory changes such as a regulator making generators liable for all transmission losses or retroactively cutting down pre-agreed feed-in tariffs.

Replacement cost-The cost of a seller having to replace the PPA’s fixed price in case the counterparty defaults on its obligations or goes bankrupt. You need to determine which portion can be recovered given market prices in force at the time of this default. Whether prices are lower or higher will define the size of the loss. Mitigation tools are guarantee instruments, such as PCG or Bank Guarantees.

Revenue Distribution Curve-It’s the curve representing simulated revenues based on the outcome of the set of scenarios considering volume, price, and profile factors deviations. The narrower the curve the more certain is a revenue outcome as the range of outcomes is smaller. The higher the curve, the more scenarios resulted in this specific revenue outcome.

Seller- The legal entity responsible for the sale of the energy produced by a renewables project, often a special purpose vehicle (SPV). It would be the generator, or a utility because the latter acts both as a buyer and a seller in the PPA sphere. Sellers are also called generators, producers, and suppliers.

Settlement location-In a financial PPA, or in a CfD, the settlement location (also known as node or trading hub in trading lingo) is where the electricity is sold to the wholesale market. In a cross-border PPA, consumption and production are in different countries. Where the energy will be settled (sold) is an important consideration.

Settlement risk – is the risk of a party not receiving the money for its delivered energy, also known as invoicing risk.

Spot Prices-Spot prices reflect how much electricity is being used. Prices are usually low in the early hours of the morning before people wake up and businesses and factories start operating. Spot prices are usually higher in the mid afternoon or evenings when people and businesses are generally using the most power.

tack-and-roll  –This is  a hedging strategy where the total exposure of a trader is stacked (e.g summed together) and hedged with futures (short-end instruments). Because there are typically no long-term electricity contracts to hedge with, the entire exposure is stacked, hedged and when short-term contracts expire, they are rolled over into new contracts on the remaining exposure. Execution of a stack-and-roll strategy entails both extra cost and risk. Rollovers require crossing the bid-ask spread, resulting in a cost, whereas residual price risk of the stack-and-roll strategy (out of contango/backwardation changes) is charged for by market participants. In a PPA, the off taker assumes this risk, charging it to the seller via a price discount. The sum of rollover cost and risk discount is termed Liquidity Premium.

System Price-Electricity system prices is the spot market price at the end of each settlement period. Calculation methods differ between countries, but they usually depend on supply, demand, imbalance costs and other defining parameters. When forward prices are discussed, typically one refers to system prices. System price forwards are an imperfect hedge for a renewable producer as the underlying production is remunerated in local area prices.

Term The term of the PPA contract, from start to the end date, also known as the delivery period.

Volume risk- Renewables’ production volume is driven by external factors such as wind speed and solar irradiation, which are subject to fluctuation. This introduces uncertainty to the likelihood of achieving expected volumes and meeting contractual obligations. The annual energy production of a renewable asset is an estimate and the uncertainty around it is typically calculated and assessed on basis of long-term meteorological data.  Volume risk illustrates the long-term variations between expected and actual production, contrary to profile risk.

The negotiation of a PPA can be complex and requires careful analysis from both the seller and buyers point of view the focus being on price variables and risk and requires experienced legal and technical knowledge and support.

Sanicki Lawyers have reviewed and advised clients on PPA agreements for solar farm projects in Sri Lanka and Africa and also for Australian clients looking to reduce their electricity costs to their multiple sites.