How Supply & Demand Drive Prices and Structures?
A webinar was recently hosted by Leoncio Montemayor, project manager for the events management consultancy Solarplaza, in which Luca Pedretti, the COO and co-founder of Pexapark, was the featured guest speaker.
Perceptions can be everything
The opening question posed to Luca was on the demand side, and specifically, how much demand (or risk appetite) he estimates there is for new built renewable capacity long-term power purchase agreements (PPAs) in Europe. Luca’s insights on this matter are derived from Pexapark’s work on more than 25 PPA transactions across Europe and the US and its proprietary PPA pricing engine over the last 12 months.
Whilst the estimated numbers (in Gigawatts) are known, Luca asked the audience's estimates, since he is very conscious of the fact that supply and demand are predicated to an extent on perceptions of said supply and demand. After all, in investment markets, perception is very often (almost) everything.
Half of the respondents (49%) estimated the demand to be 20GW, with another 30% estimating it to be 10GW. Luca then provided a series of maps with estimations of Europe-wide demand for long-term PPAs from international utilities. Pexapark estimates current long-term PPA demand in Europe at 8-10 GW.
These summarized the most high-profile offtakers across Europe that offer long-term PPAs in more than two countries. Of course, there will be additional, local offtakers in many countries and regions, such as in the Nordic countries or in Italy and Spain.
Perceptions can also be wrong, however…
Based on these offtakers across most of Europe, the estimated total risk appetite for long-term PPAs is approximately 7-9GW per annum, quite below the amounts estimated by participants in the webinar. It should be noted that local suppliers are not counted in this estimate.
Can corporate buyer make the difference to long-term PPAs?
In Europe, corporate buyers may account for up to 20% of all transaction completed. As deal activity has been very concentrated in a few areas, additional demand for long-term corporate PPAs considered saturated after a series of transactions have already been undertaken.
This corporate demand stood at only 1.8GW in 2019, of which 1.5GW was for ongoing transactions, which is less than the 2.3GW of reported transactions in 2018. This signifies that the energy demand side remains low and a push is needed to raise this demand. The crux is how best to achieve this - an issue not easily addressed.
There has, however, been a significant wave of new transactions in countries such as Sweden, Norway, Finland and Spain, mainly driven by international tech companies.
There is an ongoing belief that corporates will be the ‘saviours’ of long-term PPAs. Is that necessarily true? Luca believes that what needs to be done is to make long-term pricing structures (in the form of long-term PPAs) as attractive as possible to producers and investors. He believes that the best way to achieve that is by offering long-term fixed prices that are eventually below current market prices.
A dominant threat for corporates is timing risk, whereby they are compelled to buy all their electricity at one point in time. This is understandable given how electricity costs can be such a significant portion of total production costs, ranging from 25% of overall costs in the paper production industry, to nearly 50% for the chemicals industry, and in excess of 50% for aluminum/steel production.
Without a properly designed procurement program, industrial buyers would be at the mercy of the whims of the volatile energy markets - sometimes they can win, sometimes they can loose. Typically, over the long run though, it is not possible to beat the market performance.
Corporates, therefore, tend to have by nature only little appetite for large energy transactions that long-term PPA represent and which are so much sought for by those required for new renewable projects under traditional project finance schemes. As such, total demand from corporates is quite low. Take Germany, for example: the country’s total energy consumption is at 531TWh, of which 249TWh is industrial consumption, i.e. 46.8% of national consumption. Of that, we estimate only 50TWh to represent actual long-term risk appetite. The growth of this demand is at merely 1% a year.
Can data centres save the day for corporate uptake of PPAs?
As with corporates generally, the answer is: to a limited extent, yes, data centres can make a difference to long-term PPA uptake, but mostly not.
An interesting extrapolation is that of data centre electricity demand, which is currently estimated 50TWh of the 1000TWh Europe-wide industrial demand. Good data is very hard to get. Even with tremendous growth due to data centre energy needs, at about 10-20% growth per annum, this would only translate into 2-4GW of additional demand for long-term PPAs.
Bloomberg estimated new builds to be 19.3GW for wind power and 17.8GW for solar power in 2019 alone, which are certainly important estimations when considered within their given context. Bloomberg further estimated that 35-40GW of wind and solar builds would be added per annum going forward. While currently much of this capacity is still realized with some sort of state support, it is difficult to imagine how the entire volume could be realized with long-term PPAs from private buyer. The total demand from the private side is currently estimated at just 8-10GW per annum.
There are some market variations between different countries but, for the most part, it is important to note that long-term PPA markets are mostly skewed to the buy side.
What does this all mean for the pricing and structure of long-term PPAs?
Luca believes the results of this are essentially three-fold:
Firstly, the expectation based on economic logic is that an oversupply should mean lower prices.
Secondly, an oversupply may imply higher risk premiums.
Thirdly, this allows offtakers to shift more risks to the producers (suppliers).
As the long-term PPA market is very illiquid and non-transparent. Developers or investors interested in long-term PPA prices have to invest considerable efforts to procure prices in the market. Finding out who is offering, signing NDA, describing the project, requesting a product offer. Pexapark is working to radically simplify this process. The company build a proprietary pricing model for long-term PPA applying risk management and hedging techniques as commonly used by utilities and traders in the PPA market.
Based on this model, which is constantly calibrated with market prices and quotes, Luca was able to show how examples of clearly backward forward price curves partly due to the oversupply of long-term PPA offers.
The importance of the ‘Nordic setback’
Prices are calculated daily by Pexapark. These prices move closely with forward price levels and liquidity, the latter of which is one of the key factors regarding the pricing of PPAs in Pexapark’s view.
For example, this was seen in the Nordic markets in late 2018 in which the default of a trader had a significant negative impact on liquidity on forward markets. The price didn’t change much, but the risk appetite at those utilities offering long-term PPAs did shrink.
Hence, there is now greater difficulty today in securing larger transactions sizes in the Nordic countries than there was just six months ago. This Nordic ‘setback’ demonstrates that there is no ‘natural’ long-term PPA market.
It remains highly dependent on forward markets where there is liquidity and risk appetite. This is in stark contrast to corporates for which the requirement to buy electricity for their consumption needs is constant and for which planning is essential.
The realities of an over-supplied market
Another important trend which Pexapark believes is since there is more supply than demand is that the PPA structures in some markets have become simpler. Pay-as-produced is the structure whereby a producer is not hampered by factors such as when to produce and how much to produce, in that the offtaker will always pay the same price.
It was the prevailing price structure for the renewable energy market for many years. That has changed…
Now: energy producers are like energy merchants
The trend now in certain markets, however, is that offtakers don't provide such full-service structures anymore. This means that there is now more risk being borne by producers, which is known as a baseload hedge.
With baseload PPA more risks shifted to producers. With that the need to price risks borne by producers becomes much more important. The challenge is that many lenders have been used to providing loans to producers based on fixed 10-year pay-as-produced pricing structures, and are not yet used to structures with more merchant risks…
So, there is a strong trend for producers ‘in going merchant’. But what are the main challenges to be considered by ‘merchant producer’? Is it to find and educate investors regarding merchant risk/return profiles? Or is it in finding lenders willing to lend under merchant structures? Or is it the pricing and quantification of risks and uncertainties? Or is it the ability to manage energy risks on a continuous basis?
Perhaps all are considered important potential challenges? This new ‘merchant world’ for producers has certainly been a paradigm-changer. Before, producers didn’t need to quantify energy risks per se; rather, the emphasis was on technology risk in which energy risks were de facto externalities. However, now with a subsidy-free renewable energy market based on PPA (i.e. what the open market dictates), there is far more investment in risk management capabilities, with greater transparency on positions, revenues and risks and in which the effective management of risks on a project and portfolio basis is critically important.
Luca firmly believes that the resultant sophistication from this new risk management regime within the renewable energy market should be an exciting development in the coming years.
An interesting Q&A session
Some pertinent questions arose at the conclusion of Luca’s discussion for the webinar. One question was why the initial PPA with an offtaker is only for 5-10 years.
Why not for the entire duration (say, 20-25 years) of a renewable energy project? What guarantees does the investor have that a new PPA will be available after the first 5-10-year period has passed?
The answer is that from the utility’s point of view, they are both risk managers and traders, and so have incentives to ensure that the risk is spread out and that the project can be funded for its lifetime. What of the eventual shut down of coal-fired energy was also taken into due consideration? It is an interesting question related to the risk appetite estimation of roughly 8GW.
The response by Luca was that current market prices typically incorporate status quo regarding planned additions and phase outs in the European energy market. It was acknowledged that other factors in the market, such as interest rates in the market or regulatory changes, could indeed alter long-term PPA offerings. Another question posed was whether the market would become more liquid as more PPAs became active, to which Luca responded that he believes the contrary is true. He counters that more PPAs will simply mean more sellers in the market. Hence, higher risk premiums and increasingly simpler structures will be the net result.
More liquidity will require both more sellers and more buyers Is there any way in which to shift the market from being a strongly buyer’s market, as it currently is, to a more balanced one between buyers and sellers? Luca believes that the biggest potential for that to occur is on the corporate side,. The biggest challenge will be the availability of credit.
Credit risk insurance would certainly assist in allowing corporates to procure more PPAs, he believes. And what could be the role of banks in this context? Luca believes they have the same challenges as investors. Their preference is still for conservative, ‘reliable’ pay-as-produced pricing structures. Banks still need to come to grips with the dynamics of energy producers as merchants. Understanding energy risks and being able to quantify them will certainly become far more important in the emerging long-term PPA market for renewable energy.
Remember the natural gas market…
Ultimately, the analogy with the natural gas industry remains as pertinent as ever: 25 years ago, much of the industry’s investment was funded on fixed 25-year “take-or-pay” contracts. Today, the liberalized natural gas market is entirely financed – but running mostly on spot pricing.
Capital market have adjusted... The same could be expected in the renewable industry market.
For Luca and Pexapark, this evolution for the renewable energy market is inevitable - and it will be fascinating.