The past year has been the ‘rainbow after storm’ in many aspects, but not all. Following the progressive settling of the pricing and regulatory turmoil, the renewables industry has been confronted by a snowball effect of changes in market fundamentals, resulting in spiking construction, operational, and funding costs. All while power prices dropping well below 2022 levels.
What are some key learnings from how the industry can manage these new realities? Luca Pedretti, Co-founder and COO at Pexapark, reflects on the most impactful ‘payoff’ practices, and what it takes to get there.
In the echo of a two-decades-long race for growth, renewables seem to be entering a new era, prompted by the need to manage the maturity pains of margins compression, tight returns and higher system costs.
These new circumstances necessitate a recalibration of investment strategies underpinned by operational performance excellence initiatives around capital discipline, cost management and asset optimisation. Most importantly, there’s a significant attention shift to proactive revenue strategies, taking advantage of the fact that the untapped cost-saving and risk-reduction potential lies hidden in many renewable portfolios.
Fundamentals that weighed in on renewable energy valuations
Changes in the macroeconomic environment and the impact of rising renewable energy penetration on energy economics have ‘joined forces’ to increase costs and reduce profits for renewable assets substantially in the recent years. The most immediate effect was a sharp decline in fundraising for private infrastructure funds. According to data from Infrastructure Investor, fundraising plummeted from an annual EUR 140 billion in 2022 to EUR 27 billion in the first nine months of 2023. What happened?
Fundraising activity, 2018- Q3 2023
Source: Infrastructure Investor
Cost of debt
The cost of debt has risen, primarily as a result of rising base rates. The 10-y Euro swap rate surged to a peak of almost 3.9% following a continued upward trend over the past 18 months. Lender margins are reportedly largely unchanged, indicating continued bank appetite for the sector. The rising cost of debt and equity capital then served a further blow by increasing the discount rates at which assets are valued.
10-year Euribor swap rate, Jan 2020- Nov 2023 (%)
Over 2023, power prices hovered around EUR 60/MWh for average long-term PPAs across Europe – down from an average of EUR 90/MWh in 2022. In November, the Daily Valuation Curve (a long-term valuation framework for the entire lifetime of a renewable energy asset combining market and fundamental data produced by Pexapark and AFRY) for the period 2024-2033 was on average EUR 20/MWh lower than a year ago.
EURO Composite PPA Index, 2023 (EUR/MWh)
Source: PPA Trends, PexaQuote Note: The EURO Composite Index is an average of 10-year solar and wind pay-as-produced PPA prices across Europe, for a commercial operation date in Y+1 and Y+2 (rolling average)
Over the past two years, as more intermittent power joined the grid, imbalance prices have increased steadily, resulting in often elevated balancing costs. Last year, as high electricity price volatility exacerbated these market fundamentals, the prices quoted by vendors serving as Balancing Responsible Party (BRP) spiked to EUR 7/MWh. Even though in 2023 balancing costs dropped to approximately EUR 3/MWh, they remain higher than the long-term average.
For renewables’ owners and operators, such development has manifested through augmented route-to-market expenses and balancing costs, which plays a critical role in an asset’s revenue stack. Given the energy transition state, elevated system costs are here to stay, becoming a staple consideration for renewables investment strategies.
While some of these increased costs have been offset by heightened revenues from Guarantees of Origin (GoO), the net effect has been negative. So where shall players look for value drivers that will move the needle? The answer lies in working renewables asset as a portfolio while deploying active top line revenue management practices.
Ultimately, we believe renewables as an asset class will adjust successfully mimicking patterns observed in similar high capital-intensive industries where a race for growth is followed by consolidation and focus on performance excellence. In this new era, clean-energy focused IPPs and Funds appear to be prioritising much stronger top-line revenue management control. According to our experience, here are the most promising areas of revenue management.
High ‘Payoff’ practices for top-line revenue management
According to the real case studies we’ve worked on, embracing proactive revenue management can come with a particularly high return on investment. The direct payoff practices are threefold: a) Turning ‘invisible’ portfolio effects into measurable revenue b) Optimising revenue through mixing Long- and Short-term PPAs c) Minimising Route-to-Market costs through dedicated portfolio management.
Payoff Practice 1 – Portfolio Optimisation: Turning ‘invisible’ portfolio effects into measurable revenue
Utilising the well-known diversification effects and structuring portfolios across diverse markets and technologies can lift revenue forecasts in a down-case by 30%, compared to a single asset-based view upon which most current business model rests, if such hidden value is not yet reported.
When asset owners know how to read between the lines of their portfolios, it allows prioritisation of asset investments that optimally complement the risk profile of a portfolio, enhance debt capacity and possibly reduce unnecessary hedging costs. Even in established funds/portfolios, this avenue is already possible through multi-asset PPAs, which leverage some portfolio benefits without affecting the non-recourse financing structure.
Payoff Practice 2 – Revenue Optimisation: Capitalising on Shorter Term PPAs
Volatility in the electricity markets can lead to significant pricing spreads between Short- and Long-term PPAs. As of November, the difference between 5- and 10-year PAP deals averaged 18 EUR/MWh across key European markets. As the spread widens, revenue and financing strategies might adjust to reap this higher upside. In a market where a 5-year PPA pays 15 to 30 EUR/MWh more than the 10-year equivalent, there is a strategic risk-return optimisation play in accepting higher financing costs against significantly higher revenues.
Leveraging a medley of ST PPA (5> years) may also unlock a larger pool of offtakers, particularly corporates, whose buying need typically is skewed to shorter tenors and hence are excluded or do not participate in the 10-year PPA market. Despite 2023’s PPA boom, corporate needs remain vastly larger than the numbers indicate. On a similar note, historically many utilities have had mandates to trade up to 5-years ahead. Hence, there is also a structural advantage in speed and scalability if shorter tenors are more embraced by sellers and financiers alike.
Spreads between 5- and 10-year PPAs in key markets (EUR/MWh)
Source: PPA Prices, PexaQuote (as of Nov 2023)
Payoff Practice 3 – Portfolio Management: Route-to Market Cost Savings
From our firsthand experience, we’ve seen that investing in portfolio management and PPA negotiation specialists can lead to substantial cost reductions related to route-to-market activities and PPA management.
As costs increase and margins tighten, such benefits become ever more visible especially in high price volatility environment as currently observed. When our Portfolio Trading Services (PTS) team has supported our clients, in a typical larger-sized fund of 2-3 GW route-to-market costs can reduce up to 25%, which are estimated to deliver gross savings of up to EUR 2m per year. Likewise, revenues from power sales could increase by 15%, while GoO revenues by 50%.
In the case study below, we have used current levels of power prices to hedge the full portfolio with a mix of tools, which results in a revenue improvement potential of EUR 23.1m. According to our stress testing, the revenue improvement potential would still be EUR 14.85m even if power prices would return to historical levels.
Case Study: Comparison of Pexapark’s PTS team and a client’s approach on portfolio management
Note: The table illustrates the share of the portfolio that can be actively managed (unhedged), which stands at 1,500,000 MWh. Timeframe: One year
For the above illustration, we analysed a fund with a 3 GW operating portfolio across multiple countries; an average hedging ratio of 75%; and the need to conclude 1-2 Long-term PPAs per year to secure revenue and financing of new assets. For such a fund, our experience indicates direct and indirect cost of up to EUR 7-8 million per year. While approximately 70% of these costs are hidden in Long-term PPA fees, a hefty cost of more than EUR 2 million flows out in form of extra fees, margins and mark-ups purely from route-to-market operations.
How to get there: Top Investment Priorities for 2024
In order to take advantage of the abovementioned practices, players managing renewables portfolios need to invest and built operational excellence capabilities. The below is our selection of investments that have the ability to move the needle.
Investment Priority 1 – Portfolio Risk & Opportunity Assessment to reveal portfolio value
Timeline: 6-8 weeks Cost: EUR 50k for external support, validation and benchmark
A core first step is to create a systematic overview of risks inherent to the existing portfolios. This can be done by examining the size of the open positions (unhedged volumes outside long-term contractual arrangements) and the associated residual risks, while profiling the recurring tasks and processes related to revenue management.
If a dedicated project manager is in place, with all the required information at hand, such an undertaking can typically be accomplished within 5 to 10 working days. This exercise shall provide for a solid assessment of organisational readiness and give the opportunity for correctional actions where needed. Some of the questions that will arise are:
- Do we have access to all production data?
- Do we have all our PPA and route-to-market contracts filed?
- Do we know when each contract is up for re-negotiation?
- Do we have exotic clauses that are affecting revenues?
- How much profile and replacement risk do we have?
- Can we aggregate assets to reduce hedging costs?
One key challenge to deploying top-line revenue management practices is that the responsibility of knowing the answers to the questions above is often dispersed among various stakeholders in the organization, without clear ownership of the task. At the same time, the technical know-how and experience with commodity markets often varies between the teams.
This means that often, the organisation doesn’t have the knowledge to ask the right questions. A useful start can, therefore, be a workshop bringing together all stakeholder to create a shared understanding among all internal stakeholders of the relevance of revenue management and the operational gaps.
Coupled with a profiling of the current risk position and a benchmark of in-house processes vis-a-vis industry best practices, such a workshop can kickstart a journey of organisational transformation to excel in squeezing out more value out of existing assets. It can also help avoid the pitfalls of trying to reinvent the wheel through ‘overcorrection’ instead of taking advantage of custom solutions where best practices are already adopted and an organisation can draw on established risk methodologies as a good basis for the next growth era.
Such an assessment will act as the guiding light for any arguments and business cases to be presented to the management board. For example, it could make CFO approval of necessary investments in the team and required infrastructure such as access to databases, prices and analytical tools smoother.
Investment Priority 2 – Dedicated PPA Team equipped with the right tools to source, structure, price, negotiate and (actually) close PPAs
In-house hiring timeline: 6-12 months to get a minimum 2 full-time equivalent (FTE) comprising 1 PPA Originator and 1 PPA Pricing & Market Analyst up and running
Infrastructure Cost: EUR 50-100k to equip the team with accurate PPA pricing tools, data and market insights
Long-term PPAs are still at the core of achieving acceptable levels of revenue visibility to secure the lion’s share of financing requirements. Although the European PPA Market has gone strides in terms of maturity and sophistication since its nascent days, it remains young and rather illiquid in comparison to other commodity sectors, with all the challenges that come with lack of liquidity. For example, in the O&G sector, there are multiple hundreds of transactions taking place daily.
On the contrary, even though 2023 has seen record activity, the sum of Long-term PPA transactions until November amounted to 250. At the same time, the offtake side is fragmented and limiting in terms of the pool size. Players come with different levels of skills and capabilities, which in illiquid markets translates into large bid/ask spreads.
Pricing is different to valuing a PPA. To access to fairly priced PPA with the right risk/reward balance, a dedicated “feet on the ground” investment both in in-house talent and the necessary tools is hence essential. To move the needle in successful negotiations, PPA teams need access to benchmark PPA prices underpinned by a trusted and market-reflective methodology, compare the risk/reward balance with quant tools, and keep on top of case-specific market nuances through the right intelligence.
Investment Priority 3 – Enhanced data control, investment analytics and risk & revenue reporting infrastructure
In-house hiring Timeline: 6-12 months to get 1 FTE Risk Manager & Analyst up and running
Infrastructure Cost: EUR 200k for software infrastructure
A main challenge to top-line revenue control and active risk management is the fact that in many organizations the respective data, and risk and revenue reporting is not yet in place. The valuation framework and the corresponding performance indicators are not there to show the explicit on-going value from PPA Origination, Portfolio Management & Optimisation.
While technical assessment management systems allow most organizations to report their lost or at-risk MWh from planned and unplanned outages, such losses are not translated in “EUR/MWh” revenue losses, costs and risks from realised and unrealised production. Above all, often there are no tools to translate individual assets performance to portfolio revenue, risk and new investment decisions.
As the industry matures, the revenue bridge is extending significantly. Asset owners need clear data and dashboards that attribute changes to expected revenue, with a focus on the value created from astute commercial decisions. This means separating the impact of changing price curves on the “natural” position of the asset from changes to mark-to-market valuation of existing contracts.
The difference between those two indicates how well past hedges have served the asset. When a commercial manager originates new transactions, these can also be separated to show the value added by the manager’s transactions. Lastly, since a key goal of hedging is reducing risk, owners should also consistently measure changes to Revenue-at-Risk as an indicator for the value-add of the portfolio manager. Closing the revenue bridge and presenting such data in a timely and intuitive manner requires new systems.
With such enhanced revenue and risk reporting capabilities, the portfolio value of the underlying investments can turn from ‘hidden’ to ‘explicit.
Measurable KPIs for price fixing and risks reduction
Investment Priority 4 – Reduce Route-to-Market costs by leveraging a Portfolio Management team for tendering and strategic positioning to reduce operational costs
In-house hiring Timeline: 6-12 months to get 2 FTE consisting of a Portfolio Manager and Pricing/Market Analyst up and running
Infrastructure Cost: EUR 100k for software infrastructure
Hedging and RtM costs now play an important role in a portfolio’s revenue stack. Numerous times, we have observed that a Portfolio Management team taking care of existing PPAs and open positions, coupled with a dedicated Pricing & Analytics Expert can save up to 25% of these costs if equipped with the rights tools and mandate.
Historically, most investment funds have chosen to outsource the day-to-day management of the position and go-to-market contracts to a utility/trader offtaker as standard option. Many PPA contracts come with ‘full service’ packages, where the offtaker is also in charge for the sale of GoOs, management of unhedged volumes, and balancing responsibilities.
Benchmarks can quickly reveal that such outsourcing is often not efficient given a certain size of the fund, as the bigger the portfolio the more value in-house management of such tasks entail. Therefore, the issues are two: a) the cost/reward balance is not optimal as a portfolio grows b) the tasks are not performed on a best effort basis. For example, open position management cannot be performed based on the best opportunistic approach and is often limited to channels bounded by the assigned party.
Additional benefits stemming from Portfolio Management activities generally a lower rate of errors and extra revenue capture through the increased agility and ability to capture ad-hoc opportunities such as short-term PPAs, opportunistic opt-outs from subsidy schemes, and similar short-term optimisation opportunities.
Last but not least: How does the new portfolio valuation frontier look like?
Both theory and practice confirm the benefits of the abovementioned practices. Therefore, if we take as a given that diversified portfolios have a higher value and shorter tenor PPAs can enable more attractive risk returns, then the main challenge lies around mindset and behavioural/operational adaptation on how the industry understands and measures risk-adjusted renewable valuations.
Today, asset owners often quantify the production side with a few volume-related scenarios. The revenue side is only modelled under the assumption of fully de-risking tools, such as 10- year Pay as Produced (PAP) PPAs. Non-hedged positions, such as residual merchant tails, are valued against fundamental scenarios.
On a portfolio level, the drawback of such valuation practices, and ultimately performance reporting approach, is its inability to show the value of the portfolio to take a probabilistic view of outcomes considering both market parameters and how the risk profile of the assets correlate. This doesn’t only bear the risk of downplaying portfolio value that can lead to reduced fundraising and moderate shareholder satisfaction, but above all missed revenue opportunities.
For example, while it is already a risk to engage in hedging with Baseload PPAs or shorter PPAs without such a system, more sophisticated investment and revenue strategies are simply ruled out due to inability to understand the associated risk.
Merchant risk requires risk-adjusted valuation
At the same time, a risk-adjusted valuation model for individual assets has the ability to represent different PPA structures on the basis of both market and fundamental views of prices. To this end, many investors and lenders are moving to blended curves that cover the entire spectrum and do not display merely prices but also make statements about the price volatility.
Ultimately valuations are to be reported taking into account more sophisticated input factors, as illustrated in the table above, so that risk and revenue can be shown both on asset and portfolio level and dissected for different risk-adjusted returns levels.
The past 24 months have already acted as a ‘shock therapy’ on many levels, and we are now firmly in a new development phase of the renewable market where more and more renewable players are already deeply engaged in harnessing best practices for the next growth phase.
Ready to take off?