In the first article of the four-part series, we looked at how the cheapest electricity is the electricity that you do not use and the many opportunities to capture the low hanging fruit of energy efficiencies.
In the second article, we looked at how savings can be achieved by purchasing electricity at wholesale market pool prices and then achieving even further savings by employing Demand Side Management or Demand Response strategies.
In this article, we will look at another supply arrangement that is increasingly being used by large businesses to reduce the cost of purchased electricity at well below the standard retail fixed prices. This supply arrangement is called the Corporate Power Purchase Agreement or Corporate PPA and it offers businesses the opportunity to lock in prices at or below the current market price for a long-term period.
The article is an expansion on Chapter 13 (Step 6) and Chapter 15 (Step 8) of my book “Power Profits — A Comprehensive 9-Step Framework for Reducing Electricity Costs and Boosting Profits”.
Traditionally, retailers contract with generators, who may be the same company, for the supply of blocks of electricity in the future which they then sell to end-user customers through standard retail contracts. These blocks of electricity are often in the form of a strip of Over-The-Counter Swaps which are contracts for the purchase of a fixed volume of electricity for a specific period at a fixed price in the future. For example, a Swap for a block of electricity could be 1 MW for Quarter 1 in 2019. This means the contract is for the purchase and sale of 1MW per hour for 90-days or 2,160 MWhs.
In simple terms, the retailer would contract for a strip, or series, of Swaps to cover their requirements for the supply to a portfolio of end users. In reality, it gets more sophisticated than this with peak and off-peak contracts, price cap contracts, options and other derivatives. For the purpose of this article, we will assume the simplest case.
The Swap is a financial derivative and not a contract for the actual supply of electricity. There is a cash flow between the generator and the retailer based on the face value of the Swap and the underlying wholesale market price. If the wholesale market price is higher than the Swap price, then the generator pays the difference to the retailer. If the wholesale price is lower than the Swap price, then the retailer pays the difference to the generator. If the prices are the same, then there is no net cash flow. There is usually a daily settlement throughout the term of the Swap based on daily movements in the wholesale market price.
This form of contract is known as a Contract-For-Difference or CFD. It allows the generator to receive a known fixed price in the future for a volume of generation irrespective of the underlying wholesale market price. Similarly, it allows the retailer to purchase a fixed volume for a known price in the future which is then passed on to end users along with a set of risk premiums, other costs and its own profit margin.
Swap — a contract between retailer and generator for fixed volume and fixed price
Contract-For-Difference CFD — the structure of a Swap — there is a cash flow between the two parties reflecting the difference between the face value of the contract and the wholesale market price
Retail contract — a contract between customer and retailer for variable volume (within limits) and fixed price
Wholesale market — the electricity market where a variable price is determined for each half-hour based on end-user demand and the electricity generation bid stack to meet that demand
The simplified relationships between the end user, retailer, generator and the market are shown in Figure 1. It is much more complex than this with market intermediaries and a financial settlement clearinghouse also involved.
In this case, there is a Power Purchasing Agreement (PPA) between the retailer and the generator based on a Contract-For-Difference (CFD) with the wholesale market price.
A Corporate PPA is a similar arrangement directly between the end user and a generator but is typically a long-term Power Purchasing Agreement with a renewable electricity generator, although it doesn’t necessarily have to be renewable. These PPAs are often negotiated prior to the development of the renewable generation assets being built as they are very important prerequisites for the project financing by the banks. It is for this reason that end users are able to enter into a PPA for long-term electricity supply at a price well below the current wholesale market price.
There are generally two types of Corporate PPAs. One is a physical PPA that is a “behind-the-meter” supply of physical electricity to the end user that is co-located on the same site. In this case, the renewable electricity proponent enters into a contract to supply some or all of its output to the end user at a pre-determined price. The electricity is not supplied via the market, or a retailer, however, there may be an agreement with the retailer to export surplus electricity to the grid at a pre-determined or floating price.
The second type of Corporate PPA and the one that we will focus on is called a “Synthetic PPA”. This is where the end user enters into a long-term off-take agreement with a proposed, or sometimes existing, renewable generator for the supply of electricity at a negotiated price. It is essentially a long-term CFD as the physical electricity supply is supplied via the retailer who may or may not be, the project proponent. The retailer typically supplies the electricity at the variable wholesale market price and there is a separate cash settlement between the end-user and the renewable energy generator based on the difference in the PPA price and the underlying wholesale market price.
The advantage of a Corporate PPA to an end-user is that it can secure long-term electricity supply for a known certain price for some or all of its requirements. The advantage to a proposed renewable electricity generator is it can secure financing for the project and a certain long-term price for its output.
The simplified relationship between the end-user, retailer, generator and the market differs from the traditional approach in that now the end-user has a direct relationship with the generator and the generator does not necessarily have a direct relationship with the retailer, although it can have a relationship or it can even be the same entity.
Avid readers of this four-part series would have noticed that, with the exception of the PPA, the structure is the same as an end-user with a pool price pass-through supply agreement with a retailer as discussed in Part 2 of this series.
So a Corporate PPA is, in effect, a long-term hedge against wholesale market pool price exposure. However, that hedge price has more recently been observed to be well below the current market prices.
Figure 3 shows a chart that was introduced in Part 2 of this series. The box plots compare actual average monthly wholesale market spot prices from July 2016 to June 2018 and observed retail price offers made throughout that same two-year period. Whilst not comparing “apples with apples” it does give an indication of the differences in wholesale prices and fixed price retail offers. On average, wholesale market prices were 26% below typical fixed price retail offers. Even lower prices could have been achieved with the market exposure approach through effective demand-side management.
Enter the Corporate PPA. There has been commentary that PPAs have been struck in South Australia at or below $80/MWh for a “firmed” product (we will come back to “firmed” products). In the Eastern States, PPAs have been reported to have been struck at even much lower prices closer to $50/MWh. Figure 3 shows where this firm PPA price level sits with respect to both the wholesale prices and the fixed retail prices over the last two years.
If you were an end-user who has been taking pool exposure in South Australia then a PPA offer of $80/MWh would look very attractive as a hedge, at current market prices. If you were an end-user who used a more traditional fixed price retail contract then a PPA offers the opportunity to reduce the energy component of electricity bills by more than 40%.
Of course, the above scenario is highly simplified and negotiating a PPA is much more complex. The most obvious issue is that a renewable electricity generator such as wind or solar does not have a continuous flat output. Wind generation depends on the wind blowing and wind strength. Solar generation depends on the time of year and the extent of cloud cover. Both depend on design issues, quality of components and ongoing maintenance.
The box plots cover two-years of price data but a PPA is most often for a period of more than seven years. So it is important to have a good understanding of the market and market trends and form a view of likely future prices when negotiating a PPA.
PPAs have a wide range of permutations of contract parameters that the end-user needs to be very wary of when negotiating an agreement. Some of the most obvious ones are:
1. Does the agreement contract for a certain percentage or all of the actual sent-out generation? i.e. does the end-user takes the generation volume risk?
2. Does the agreement contract for a fixed volume based on a modelled output from the generator? i.e. the generator takes on the generation volume risk and supplies a fixed volume.
3. Does the agreement contract for a fixed flat volume and fixed price with the renewable generator providing a “firmed” product? i.e. the generator takes on the generation volume risk and hedges with other parties to provide it with fixed prices on the additional volume required when the renewable generation isn’t occurring, known as “firming”.
4. Does the end-user receive Large Scale Renewable Generation Certificates LGCs as part of the agreement? Does the end-user receive certificates on a 1:1 basis of volume contracted or based on the mandatory surrender rate for each year?
5. Is the entire output from the renewable generation project dedicated to the one end-user or does it supply a portfolio of end users? How is the actual generation allocated? Does the end-user have any control over the generation operation?
6. What is the term of the agreement? Is there a buyer option to extend at the end of the term? Most PPAs are at least seven years in order to achieve financing from the banks.
7. Is there an annual price escalation clause? What is the formula?
8. If there is a change in the law in regard to LGCs or a carbon trading scheme introduced which party bears the risk or receives the benefit. E.g. if a carbon trading scheme is introduced and the wholesale market price increases as a result, how is this taken into account in the CFD?
9. Will the renewable generator also provide the retail service? If so, what are the retail service charges?
In addition to the different contractual forms that a PPA can take, there are also several risks that the end-user needs to be aware of and manage. The most important are:
1. Counterparty risks — the risk of the renewable electricity project not going ahead and conditions precedent not met or the risk of the project proponent financially failing and going into liquidation
2. Volume risks — the risk that the project will not generate the expected volumes (depending on which party is wearing that risk) or the end-user having much higher or much lower consumption volume than planned. For example, an effective energy efficiency program could drive consumption below the contracted volume.
3. Profile risk — the risk that the generation volume is different than modelled. For example, if there was a change in long-term wind patterns that was far different from the initial modelling. The end-user usage profile could be different than planned resulting in a mismatch between the planned generation and usage profiles.
4. Price risk — although current PPAs are being priced well below current wholesale market prices, an increase in renewable generation penetration could drive long-term prices down below the PPA prices over the term of the agreement. This would mean that the end-users with PPAs struck, say in 2018, could be paying higher prices than the fixed retail contracts and wholesale market prices in 2022 and beyond.
5. Legislative risks — change in law. This is particularly relevant in energy legislation in Australia. Changes in government can result in significant legislative changes that can impact the value of LGCs or the costs of renewable generation.
6. Accounting risks — a CFD is a derivative and so the end user will need to apply more complex hedge accounting treatment. If the whole offtake from a project is contracted to one end-user, then it may be considered as a lease rather than a hedge and completely different accounting treatment applies.
7. Long-term business strategy — the PPA term will most likely be more than seven years. The business needs to consider its potential operational profile in the context of its long-term strategy. For example, is the business considering rationalising operations, moving offshore, investing in expansion opportunities or embarking on an aggressive energy efficiency program.
End-users need to determine whether they want all of their electricity supply to be firm and at a fixed price or whether they want to contract a proportion of their usage via a PPA and then the balance from the wholesale market. For example, a manufacturing facility with a 30 MW load may be able to curtail half of its load for large periods. They may contract for 15 MW with a PPA and leave the balance of their requirements exposed to the wholesale market price and then use a demand response strategy to reduce the cost of the uncontracted volume.
Corporate PPAs are gaining momentum as a method for end-users to reduce their electricity costs compared with the more traditional fixed price retail supply agreements. At the moment, Corporate PPAs are being executed with very large electricity users, however, it will become increasingly popular for smaller users to combine into energy buying groups to take advantage of the same significant costs savings.
Corporate PPAs are quite complex and require a thorough understanding of the electricity market, the structure of the agreements and the significant risks. However, with risk comes significant reward.