Welcome back to Hitachi Energy’s Market Management for Renewable Energy blog series where we are taking a deep dive into the market management side of renewable energy use and projects.
Last time, we talked about investing in energy markets in the blog, New risks on the horizon for renewable energy aggregation, trading, and selling in North America
Now, we’ll turn our focus to new, more effective ways to manage energy procurement.
Organizations that consume large quantities of power are facing increasingly common headwinds in their push to use renewable energy. To reduce their environmental footprint, they are more often purchasing their power directly from renewable energy generators while at the same time looking for new ways to manage their energy procurement more effectively. Power Purchase Agreements (PPAs) make both challenges manageable.
Having gained recent prominence, PPAs are key instruments for long-term electricity procurement and supply. They offer renewable energy developers an opportunity to invest in new assets, thanks to long-term assured income, and allow developers to make investment decisions based on profitability versus risk. For energy-intensive consumers, PPAs provide access to competitively priced clean energy at a stable and predictable price.
Structure of PPAs
In PPA contracts, sellers and buyers define the terms and conditions of the energy supply, often for a 10- to 20-year term. PPAs can be structured in different ways, such as with fixed, indexed, or hybrid prices. As energy trading grows increasingly complex and challenging, the various parameters, such as prices, volumes and delivery schedules of PPAs, require careful evaluation and analysis.
Conduct modelling and pre-deal analysis
If you are a renewable asset developer or power producer, you need to determine how to value your power and secure your investment with a certain profit margin.
Conversely, as a corporate consumer, you want to understand whether a contract provides attractive pricing now and, in the future, the associated risks, whether it reduces a carbon footprint, and how to account for these contracts.
Varieties of PPAs
PPAs come in different forms depending on the goals of the seller and buyer.
- Physical PPAs facilitate the physical delivery of energy to the offtaker.
- Akin to a financial instrument, virtual PPAs allow a company to buy electricity virtually without the need to complete the physical delivery of energy. The agreement involves the settlement of a price difference between the spot market price and the agreed PPA price. Virtual PPAs allow offtakers to hedge costs across countries and borders, though accounting requirements and basis risks need to be considered.
- Sleeved PPAs are physical PPAs that involve a third party, typically a utility, which supplies the energy to the offtaker through the grid. The utility is also able to provide additional power in case of any shortfall in projected supply.
PPA contract models
Defining and negotiating contract terms and conditions of a PPA will include pricing mechanisms, delivery schedules, risk-sharing elements, contract durations, and any embedded options or derivatives. Utilizing a fundamental power market simulation model, such as Hitachi Energy’s PROMOD, provides you with valuable information on the dynamics of the marketplace.
The model creates long-term price forward curves, as well as considers the effects of transmission congestion risk, thereby quantitatively comparing various outcomes and valuing complex PPA structures for optimal revenue and risk distribution.
Mitigate risks
PPAs are used to deal with long-term market risk, i.e., the risk of losses in positions arising from movements in market variables, such as prices and volatility. However, PPAs with offtakers, such as Commercial & Industrial (C&I), may not cover all the long-term risk. It makes hedging renewable assets increasingly challenging.
In addition to market price volatility, risks associated with structured energy contracts, such as PPAs, may include credit risk, operational risk, and regulatory changes. Because the wholesale electricity market is more liquid and pricing is more transparent, market participation might be a viable option for asset owners to access products and instruments to better manage this risk. Large energy consumers have also received a wake-up call with the increased volatility in the market, partly due to higher availability of intermittent renewable energy in the mix.
Risk mitigation strategies include using derivatives (options, futures, swaps) to hedge against price fluctuations or credit risks. In fact, some new contract structures are introduced differently than a standard PPA. They are based on a fixed shape or structured deal, which captures spot price volatility and offers a minimum level of return through floor contracts. For example, when the wind does not blow, a renewable power producer would buy power from the market to meet delivery obligations. Alternatively, in the case of surplus, producers sell excess back into the market.
To help assess future earnings and hedging strategies, state-of-the-art Energy Trading and Risk Management (ETRM) solutions – such as Hitachi Energy’s TRMTracker – enter the equation. ETRM systems perform stress testing and what-if scenario analyses to evaluate PPA performance.
Manage a complex portfolio
With the PPA contract(s) operational, you can execute trades based on contract terms and market conditions to achieve the desired risk-return, considering pricing mechanism and hedging strategies.
An ETRM system models all generation assets, manages PPA contracts, captures market price forward curves, and connects with spot markets to deliver a strong risk framework. Such a framework provides insight in the position, P&L, counterparty risk, market risk, shape risk, and Value at Risk, to construct a high-performing portfolio. While stable returns are no longer guaranteed, the ETRM system better positions asset owners to take advantage of opportunities that may increase returns.
Other than position management and PPA valuation, there is a need for reconciliation and settlement. Structured contracts are intricate agreements with various terms and conditions, including charge types, which may need to be calculated individually based on actual volumes, balancing fees, taxes, and market prices.
Complex structured contracts often require extensive verification processes to ensure that settlement calculations align with contractual terms. Companies relying on a small army of settlement analysts to manually account for their structured trades are exposed to operational risk (system failures, settlement errors, and manual trade-entry errors).
A more effective management approach involves robust systems, such as Hitachi Energy’s SettlementTracker. The solution automates settlement verification, reconciles actual energy deliveries, pricing, and performance against agreed-upon parameters. In case of discrepancies or disputes, a well-defined process for resolution is necessary to maintain trust and preserve relationships between contracted parties.
When integrated with an ETRM system, the back-office will benefit from straight-through-processing and built-in workflow management, streamlining the contract-to-bill process. State-of-the-art back-office automation helps you avoid leaving money on the table and may result in substantial savings and efficiency gains by reducing the number of employees required to manage this process and by freeing your staff to focus on other high-value activities.
Meet transparency and compliance requirements
Two other important outcomes of working with PPAs is the role of assigning Energy Attribute Certificates (EACs) and accounting for the impact of green virtual PPAs.
EACs, such as Renewable Energy Certificates (REC) or Guarantees of Origin (GO), provide proof of renewable energy generation and associated environmental attributes. By accurately tracking and assigning these attributes to the respective parties in a structured contract, EACs ensure transparency, compliance, and integrity in renewable energy transactions.
It takes built-for-purpose functionality, like Hitachi Energy’s RECTracker, to manage the increasing volume of cancellations and to automate the end-to-end REC/GO tracking from generation to assignment and retirement or expiration, with the ability to capture registry attributes that facilitate matching based on certificate specifications.
When a green virtual PPA is classified as a derivative, it may be considered a financial instrument, like futures and options, which may be accounted for in accordance with financial standards for derivative hedge accounting. Electricity and RECs/GO may need to be separated; otherwise, the fair value may be measured over the full contract. To measure fair value and recognize changes in P&L, hedge accounting solutions, such as Hitachi Energy’s FASTracker, provide advantages to financially hedge portfolios while staying compliant with accounting standards.
Move to make a difference!
Engaging in PPA contracts requires careful evaluation and analysis both for the renewable developer and the offtaker. Energy markets are subject to a multitude of factors, including price fluctuations, demand variations, and unforeseen events. To effectively manage complex structured contracts, you should implement systems and processes that can accurately model, mitigate, and manage the unique characteristics of PPA terms, market prices, and performance metrics.
This cannot be met by traditional ETRM systems alone, but in combination with pre-deal analysis and energy market simulation software to quantify whether a project and associated contract will support revenue goals and risks. This ensures that both buyers and sellers are appropriately compensated and that any potential risks or disputes related to settlement calculations are minimized while staying compliant with regulatory standards.
Hitachi Energy co-creates value with customers that are facing a fundamentally different market and supports their investing, planning, operating or trading activities for more effective decision making.
Explore how our ETRM solutions can help with your energy investing goals.