New forms of PPA are emerging that are specifically designed to enable better risk management.
Signing a corporate power purchase agreement (PPA) can reduce financial risks for buyers and sellers alike. But renewable energy projects have their own complex risk profile. No PPA can eliminate all these possible risks, and large parts of the a PPA contract focus on who bears which risks. There are a number of options for managing the outstanding risk. But with the corporate PPA market growing, the time is now right for innovative new insurance and risk hedging products to further stimulate the green energy transition.
Corporate PPAs are a great tool for financing the green energy transition and deliver wins for both parties. Buyers get economic benefits and simpler financial planning as well as a way to significantly reduce their environmental footprint. For renewable energy projects, PPAs provide a stable revenue stream that can help secure project financing.
Understand your risk exposure
As with all major infrastructure projects, there are risks involved in building, operating and financing renewable energy power plants. Many of these risks have a considerable bearing on any corporate PPAs signed with the plant. Among the most important are:
- Price risk: losses due to variations in the electricity market, for example when the spot price on the open market is lower than the PPA price for extended periods
- Liquidity risk: when electricity cannot be traded fast enough to avoid a change in price
- Volume risk: the renewable energy plant doesn’t produce the amount of electricity forecast due different resource (wind speed, solar irradiation) levels than expected
- Credit risk: the buyer is late paying, misses a payment or defaults on the rest of the contract, or the project goes bankrupt before it delivers the energy
- Profile risk: many renewable energy plants can only generate electricity at times determined by the conditions and hourly prices during these periods can affect the overall value of the electricity produced
Allocating these risks is a key part of the PPA negotiations. In large part, that risk allocation comes down to the structure of the contract. For example, in a pay-as-produced structure, the offtaker carries the price, liquidity and profile risk while volume risk is shared, with the producer being liable in case of under- or over-production. By contrast, for baseload -type structures, the producer is responsible for the profile and volume risks and the offtaker bears the price and liquidity risk.
However, no matter what, you will have to bear some risk. And that risk may be quite considerable. For example, if a buyer’s credit rating is downgraded – a common issue in the fallout of the coronavirus pandemic – then any PPAs they have signed may no longer be considered ‘bankable’, making it difficult for the projects to access financing.
Risk management options
Clearly, then, it is essential to consider your options for hedging the outstanding risk. Keep in mind that all hedging solutions have a cost, and, in some circumstances, it may be economically preferable to just keep some or all of the risk. Another option is aggregation which reduces risk by bundling together several projects or buyers.
Meanwhile, new forms of PPA are emerging that are specifically designed to enable better risk management. Among them is the proxy-generation PPA. Proxy-generation PPAs base settlement on the renewable “fuel” input to the project (i.e. the measured solar irradiation or wind speed) rather than the metered energy generated. In this way, it ensures the operational risk remains with the project rather than being passed on to the offtaker, allowing offtakers to hedge other risks through insurance and commodity markets.
On the commodity markets, both buyers and sellers can use trading on an energy exchange to manage PPA risk. For example, using so-called futures to manage price risk or hedge wind / solar generation profiles.
In the world of insurance, risk-hedging products for corporate PPAs are a new area. But useful products do exist, often based on risk-mitigation products initially developed for other industries and adapted for renewable energy. In 2018, Microsoft and REsurety co-developed the Volume Firming Agreement (VFA), which shelters buyers from volume and profile risks. This makes it useful in supporting pay-as-produced and pre-defined profile contracts. For sellers, the increasingly popular proxy revenue swap allows projects to replace its variable revenue stream with a fixed payment, while’ Solar Revenue Put de-risks solar power plants by guaranteeing up to 95% of forecast production.
Innovation in insurance
However, the PPA hedging market is still relatively small, and the limited number of products doesn’t cover the full range of risk factors that can affect corporate PPAs. So not all contract structures will be able to find an appropriate hedging solution. This needs to change to support the corporate PPA market and the wider adoption of green energy. We need more innovation from the insurance industry.
However, the corporate PPA community can’t afford to just sit back and wait for that innovation to happen. We need to be active in stimulating it, reaching out to insurers and and building bridges between the two worlds. The good news is that the growth potential of PPAs and the types of risks involved would seem to make this area a natural fit for insurers, so we can be confident that the number and variety of PPA hedging solutions will increase.
Leveraging DNV’s unique expertise in risk assessment and renewable energy technologies, our green energy procurement services support corporate energy buyers in achieving impactful green power procurement quickly, easily and transparently. Besides connecting renewable energy buyers and sellers, we offer support in risk assessment and allocation for corporate PPAs. For more information, please contact us today.