Risk Management for Power Purchase Agreements
In the course of the energy revolution, energy-intensive industries often turn to new types of contracts to purchase power. On the one hand, the design of contracts and on the other hand the hedging of their risks could lead to derivative financial instruments. If the responsibility for the conclusion of commodity derivatives, their evaluation or their recognition in the balance sheet lies with the treasury department, the treasurer needs to understand the related aspects. Before anything, the treasurer will have to determine, whether indeed such contracts should be written.
Because governments no longer guarantee compensation for grid feed-in with renewable energies, increasingly generators of such energy have to find new ways to finance their wind turbines. Because these are reliant on the weather, this means fluctuating volumes and thus volatile trading, forcing operators and their buyers to mitigate their risks in regard to price and amount. This makes bilateral contracts between generators and users ever more popular. So-called Power Purchase Agreements or PPAs are medium-term or long-term power delivery agreements between generators and buyers that may be flexible. This article will show the different forms of agreements, highlighting the risks and opportunities each contractual party has to be careful of when setting up and implementing the agreement.
PPAs are over-the-counter agreements and therefore offer the possibility to set relevant contract terms up quite flexibly. However, contracts describing similar aspects of a contract may diverge greatly from each other. This is typical of a market that is still finding its feet and that has only started to offer standardized solutions with increasing liquidity. As these types of power purchase agreements have become more common, the European Federation of Energy Traders (EFET) has prepared a contractual template which contains all of the standard clauses and optionalities. It has also set up a framework, which it hopes will become the market norm. These contracts can thus not only define the regular parameters, such as the purchase order, delivery times and pricing, but also mutual codes of conduct, maintenance duties or cancellation clauses.
Basically, two main types of PPAs seem to emerge in the market. In a physical PPA, the producer feeds into the same pricing zone as the one where the counterparty draws its power. This means that there is a direct and physical delivery which is also relevant to the accounting grid. In this case, it is not absolutely mandatory that the producer be in the same area as the delivering party. However, if there is such a proximity -- for instance because there is a power station in the industrial park -- this form of contract is called on-site PPA. In the case of an off-site PPA, the producer delivers the power to the user through a public grid. Because of that, the amounts have to be settled through the involved accounting grid. If the producer in an off-site PPA also acts as intermediary (because it takes care of certain processes), this is also known as a sleeved PPA.
Synthetic PPAs, also known as virtual PPAs, act as a platform for electricity producers and users coming from differing pricing zones. Here, there is no link between the physical flow of energy and the cash flows. For instance, this could be done with the help of a Contract for Differences (CfD). A CfD defines the price of electricity in a contract. If the spot market price is below the fixed price, the user has to pay the difference to the producer. If the spot market exceeds the fixed price, the cash flows are inverse. In this scenario, the producer sells the produced amounts on the spot market.
For the actors in the power market, the advantages of PPAs are among other things the following: Possibilities to finance investments in new electricity-producing capacities, long-term price security, assurance of renewable energy or risk mitigation regarding the purchase and sale of electricity.
The valuation of PPAs is a challenge for the contractual parties due to several factors. On the one hand, fluctuations of produced amounts have to be forecast and on the other hand, the development of electricity prices has to be anticipated over a longer period. We will briefly outline the main risks of PPAs below.
The biggest problem is the determination of future price levels. The long-term nature of contracts often makes it hard to find robust prices that will still apply at the long end of a forward curve for electricity. This so-called illiquid part of the market has to be determined with internal models; alternatively, a company may choose to purchase price forecasts from external vendors. The resulting price risks arising for the buyer intrinsic to the instrument and the model used must be carefully supervised and hedged. It turns out that standard EEX electricity futures are ideal hedging instruments. They allow the hedging of the price risks for a period of up to six years in a liquid and standardized market. Various strategies may be used depending on the expected volume of electricity. Generally, companies choose a dynamic sequential strategy to manage large exposures. Over time, an increasingly larger part of the volume to be produced is hedged for a delivery period that is coming closer. Depending on the optionalities of a PPA, more or less multifaceted hedging strategies have to be considered.
Should a producer sell in a pricing zone other than the one where the user buys, there will be base risks. Prices could develop differently in the two pricing zones thus causing structural deviations during the contract period which had not been considered at the time of its conclusion.
In long-term contracts, the counterparty risk is significant on both sides. This is why it is important to not only look at the contractual party’s current credit-worthiness but to take into consideration a long-term outlook. Bank guarantees have a risk-mitigating effect and relevant clauses that mirror the parties’ ratings enter into these types of contracts more and more often.
Volume risks are also hurdles that must be circumvented with a precise structure of the contract. Exogenous factors could affect the delivery (for instance, the down of a transmission system). Generally, bottlenecks are bridged with deliveries purchased on the wholesale market. Contracts should therefore clearly define who is responsible for the added costs.
Regulatory developments may also influence volume risk. Here, we would like to highlight the package adopted by the German Federal Grid Agency, which is meant to strengthen the maintenance of the accounting grid. In the future, those responsible for the accounting grid will be penalized faster if the producer can’t ensure a balanced load for each quarter of an hour from the accounting grid. Because of this, the quality of the forecast volume for the day-ahead market is of even more importance. Using predictive analytics based on historic values and input parameters (such as temperatures and wind data), models can be trained in order to predict production volumes that are as precise as possible for the short-term day-ahead market. These processes may be automated, which allows a continuous adjustment of the forecasts. Based on these parameters, rules may be defined for automated trading algorithms, which are capable of directly obtaining the differences also on an intraday basis. This reduces the deviation between the initial forecasts and the billed energy volume of the accounting grid responsibles, thus mitigating the overall risk of being penalized.
In view of the complexity of the contracts, the risk also increases when implementing the contracts within the system. Very often, PPAs cannot be integrated into the already existing software environment. Agile methods have proven helpful in the development of GUIs or automated interfaces. In comparison to classical project methods, solutions can be built up iteratively, which can reduce the complexity in the development.
Finally, the question arises how PPAs should be disclosed in annual financial statements of all parties involved. Especially companies active in capital markets that use International Financial Reporting Standards (IFRS) have much leeway in the approaches to be used. Depending on the contractual design and the purpose of the contract, the following accounting possibilities could be used:
Once the recognition has been selected, follow-up questions might arise surrounding the conclusion of a PPA, for instance concerning hedge accounting. Such questions should also be dealt with.
In summary, PPAs have the potential to become important instruments in the energy market. They not only allow the transfer of energy volumes but also risks between parties, so that the market benefits from an improved delivery and a more efficient risk allocation. In the long run, their extreme flexibility will make them interesting not only for operators of wind parks and solar parks, but also for other power generators. However, it should be understood that the flexibility also brings with it complexity for all those involved. Issues around risk management, the accounting and the system integration of PPAs have to be dealt with constantly.
Source: KPMG Corporate Treasury News, Edition 95, October 2019
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