Renewables is the fastest growing commodities sector, and your electricity portfolio needs to be managed accordingly. Future growth should not be dependent only on past performance. If your business is forward-looking, so needs to be your reporting. Let us explain what we mean.
The days when a portfolio exclusively comprised subsidised assets with a fair amount of cash flow visibility are ending. With market parity comes the realisation that you need to come to grips with electricity markets and concepts new for renewables energy investors – that of merchant risk and managing energy sales. Be careful what you wish for, right?
In our Market Outlook 2022 report, one of our top predictions for the future of renewables was investors turning into the next generation utilities. Among the many impacts of this new investment and operation model is the shift towards new energy risk management infrastructure to monitor the sale of a portfolio’s electricity.
The most critical part of such infrastructure concerns the way that risks are reported. In this article:
- We will go deeper into the changing market conditions leading to the need for new risk reporting and the game-changing structural benefits you can achieve by doing so
- We will provide a selection of key metrics to incorporate into your risk reporting to put a big smile on your shareholders’ faces
Spoiler alert: Anecdotal reports have a few CEOs enthusiastically cheering ‘Eureka’ for a particular metric. That’s why we are leaving the best for last.
Backwards looking performance reporting vs. forward-looking risk reporting
Performance reports are no longer enough because they are backwards-looking. On the volume side, they usually indicate how much an asset has produced and technical problems affecting yield. On the commercial side, there’s a layout of what prices have been and the revenues achieved. Sometimes they show projected revenues using forecasted prices which are updated every three to twelve months. Regarding the actual revenue outlook, visibility is limited, usually narrowed down to high-level market developments that are anticipated to impact future revenues by the end of the financial year.
This common practice still carries residues of an era where asset management was focused on operations. Active energy sales and ongoing strategic decision making were not yet important. Why would the reporting system remain the same if your portfolio is changing? Inertia is only good for the electricity grid, not for business plans. There are major reasons why you need to incorporate forward-looking risk reporting, which is merely taking control of your future revenue.
Transitioning to active management
Renewables portfolios nowadays comprise assets operated under a dazzling array of different revenue models. Monitoring asset performance becomes more complex.
Power Purchase Agreements (PPA) have come to the fore as the first touching point of investors with electricity markets. However, a PPA may not hedge the entire volume of a project. Many of our clients prefer to hedge 70%-80% of production in order to stabilise revenues to secure financing (especially debt) while maintaining some exposure to prices to take advantage of potential upside in revenues (and satisfy the equity side). This means that there is a significant amount of volume to be managed with short-term hedging decisions.
At the same time, as we noted in our Market Outlook 2022 report, high discounts on long-dated Pay-as-Produced (PAP) contracts in mature markets are pushing investors to Baseload-type PPAs and short-term agreements. PPAs with a baseload volume structure require active monitoring. To manage higher uncertainty – and to tap into higher returns – forward-looking players are actively participating in the wholesale markets, managing risks and gaining the ability to react upon timely favourable circumstances.
The squeezing of the 10-year PPA Market results in higher exposure to price risk, and constant research for higher returns. Finally, with wholesale market prices at all-time highs in recent months, many operators can now opt-out of old subsidy regimes to sell their products on open markets instead. Exposure to price risk is always there as the recent wave of unprecedented market and price developments revealed.
Increasing investor confidence
Despite renewables being one of the hottest asset classes in infrastructure investing, players nowadays need to manage decreased returns of this asset class on the back of a much higher underlying price volatility. The ability to identify, capture and manage price risk has become an essential requirement for continued success in investment & operation in renewables.
While the industry knows that increasing exposure to price risk is set to become the norm, not all financing players feel equally comfortable with the new risks that this entails, yet. For example, institutional investors such as pension funds, insurance companies and banks are traditionally risk-averse and like predictability and stable returns over a long period.
The reaction of the industry has been to rapidly increase scale, diversification of portfolio along price zones and technologies and increase control over the value chain. Putting in place a coherent energy risk management strategy and infrastructure is one of the action plans to prove that your strategy is ready to meet the requirements of an investment and operations model facing much higher exposure to price risks.
Investors, boards and investment committees need the reassurance that a consistent energy risk management culture, organization, systems, and processes are in place to manage new risks related to the added component of energy sales.
And pursuing such upgrade of the operating model will reduce the manifold procedural errors that occur when there is an absence of a coherent system. We have seen cases with hedging the same volumes twice and committing to volumes that don’t exist. A quite common error is further the manual adjustment of volume expectations because P50 is not trusted or panicked reactions when price volatility leads to historically very low or high prices.
Developing a portfolio view
Taking as a given that each power plant needs to have a robust viability case on its own, moving away from single-asset management to a portfolio view is pivotal. When assessing future revenue and risk of a renewable asset, the key challenge is the ability illustrate the diversification benefits a portfolio provides. Simply managing the revenue and risk of a single asset – which is the industry norm today – is significantly less efficient than a portfolio approach.
When an asset’s revenues are at risk, for example due to weather affecting expected volume or by market circumstances, you may need to rely upon a different asset to smooth out the overall cash flow line. To achieve this, there must be a risk correlation set up between assets.
Such strategic advantages are the reason why scaling up through smart diversification is becoming a top priority. Large new players such as oil majors and sophisticated financial players are entering the market with a portfolio manager mentality versed in the art of risk management. With advanced risk management solutions and tools available to analyse revenue at risk, are they posed to rule the new renewable world?
New risk reporting, new growth: on the road to transforming into an energy company
Against this background, some of the leading funds, asset managers and IPPs have started to incorporate risk reporting to lay the foundations for an upgraded operating model. The new frontier of the next-generation utilities is unfolding. For example, large funds are in the process of upgrading their operating model with PPA origination, portfolio management, and a risk management infrastructure such as valuation methodology.
The most critical investment concerns the underlying energy risk reporting system. Based on a robust valuation methodology, control of commercial energy data and market-based valuation parameters, a state-of-the art renewable portfolio requires a distinct set of risk metrics to report on the inherent risks to future revenue and guide investment and hedging decisions.
A selection of impactful metrics to include are:
- Position Overview
- Revenue Risk
- Counterparty Risk
- Sensitivities
- Concentration Risk & Portfolio Diversification Effect
Position Overview
On a portfolio level, the essential overview you need is your expected hedged and unhedged revenue; how your expected production volume evolves; and your hedge ratio and open position at any time. In short, think a bit more like a trader. Trading houses, larger utilities and oil majors perform this task daily, to be aware at any time of what actions they need to take. As large IPPs and renewable investment funds pursue next-generation utility-like business models, reporting needs to adapt accordingly.
At the core of any risk reporting feature, and investment decision for that matter, lie accurate analytics based on mathematical and financial models and assumptions. Business standard is to use probabilistic approaches that yield in distributions, which are essential to get a sense of variability of the possible outcomes.
The distributions are often characterised through specific points on the distribution such as P10 or P90 values. The P10 value for a specified time period, for example, indicates that with a 10% chance this value will be met or exceeded over the specified time period. Similarly, the P90 value show 90% chances for the expectations to be met or exceeded.
Indicative Case Study using PexaOS
|
POSITION OVERVIEW 2022 |
|
| Expected (based on client’s view- baseline scenario) | P90 (Monte Carlo Simulation-based) |
|
Hedged Revenue |
|
|
EUR 42,459,190 |
EUR 38,823,179 |
|
Unhedged Revenue |
|
|
EUR 77,994,715 |
EUR 65,236,160 |
|
Production Volume |
|
|
MWh 1,154,184 |
MWh 1,054,872 |
|
Hedged Volume |
|
|
MWh 806,034 |
MWh 717,748 |
|
Unhedged Volume (Open Position) |
|
|
MWh 348,151 |
MWh 317,286 |
|
Hedge Ratio |
|
| 70 |
68 |
Your starting point is to have a clear idea of your hedged and unhedged volumes. The below graph illustrates the position overview for 2022, and this can be extended to the desired timeline. The furthest you can look ahead, the more holistic view you will have. For example, hedged volumes are those covered through a fixed-price PPA, and unhedged volumes are those left to settle on the open market.
Net Position for 2022
Starting to monitor your hedged and unhedged positions to understand how much risk your portfolio is exposed to and having an up-to-minute overview of the volume that needs to be managed is the first step towards an active hedging and risk strategy. This way, management can decide if it feels comfortable with the position, and whether it wants to take additional action.
Revenue Risk
Your position overview will lead to an accurate synopsis of your revenue at risk – that is, the total revenue that your portfolio is set to make. Interesting fact: did you notice that in our case study for 2022, the majority of revenues is expected by unhedged revenues? When market conditions are favourable, such opportunities arise often. Yes, there is such thing as over hedging, and decision-makers need to be alert.
Revenue Exposure, 2022
Expected revenue is the “best guess” of the investor using average realisations of factors such as prices and volumes. When looking at an aggregated view of the total revenue, including the expected revenue and the two extreme probabilistic views (P90 & P10), the further away the distribution values are, the greater the risk. Revenue risk is driven mainly by the open position, and some from the hedged position – especially if a portfolio is also comprised by Baseload PPAs. Having an overview of where you stand will inform decisions to reach your goals. For example, by adding or removing a hedge.
Future Total Revenues, 2022
In addition, knowing the breakdown of your risks and the impact they could potentially have on your gains will give the necessary comfort to shareholders that you are in control.
Waterfall- Revenues Breakdown
Counterparty Risk
When entering an electricity sales contract, there is always a degree of counterparty risk – as in, the probability of the party that will renumerate the producer for the delivered electricity not honouring their obligation. The term ‘counterparty risk’ made it into the everyday vocabulary of the renewables industry amid the rise of bilateral PPAs between private parties. In subsidised assets, the government acts as the counterparty that ‘offtakes’ the electricity. In bilateral agreements, such counterparty is a private company, typically with a different risk profile.
It is essential to know who you are dependent on, and where your revenue risk lies. Based on the revenue exposure, you can have an early indication on how your P&L is set to evolve for the preferred timeline. Interesting fact: Do you notice that in this case study, P&L shows negative values for all counterparties? This is because the PPA price for these assets is lower than current spot prices, indicating a loss according to standard accounting practices.
This is the case for the majority of PPAs signed before the pricing surge that started in Q4 2021. Due to price volatility, it is always useful to track how your PPA is performing.
Revenue Exposure by Counterparty, 2022 Unrealised P&L by Counterparty, 2022
Sensitivities
No matter how much planning we do, life will happen. When it comes to electricity markets and renewables, there are de facto parameters that operators and investors cannot control. Price volatility is a monster on its own. Realised volume production can deviate from forecasts. Therefore, it always helps to account for changes in price, volume and capture factors – three of the most important factors of your revenue.
Deltas to expected total revenue
| Y2022 | Y2023 | Y2024 | |
| Price -10% | -7,423,186 | -4,611,090 | -3,092,513 |
| Price +10% | 7,442,381 | 4,671,817 | 3,123,147 |
| Volume -10% | -12,045,500 | -9,392,759 | -7,547,894 |
| Volume +10% | 12,045,500 | 9,392,759 | 7,547,894 |
| Capture Factor -10% | -7,805,414 | -4,811,639 | -3,261,342 |
| Capture Factor +10% | 7,824,609 | 4,872,366 | 3,291,976 |
Having sensitivity scenarios will help prepare for a pivotal trigger point, that of reaching limits. This is particularly important for asset managers, funds or listed companies which have to report progress to their shareholders in a periodic manner. By setting up a goal, and closely monitoring whether market developments are helping you achieve this, will allow for adequate time to take action if your expectations are breached.
Concentration Risk & Portfolio Diversification Effects
According to investment 101, the asset classes comprising a portfolio shouldn’t necessarily move in the same direction. If you experience losses in one asset, technology or geography, you want to make up for the losses from different ones. To reduce concentration risk, diversification is at the heart of every investment strategy. Uneven distribution of exposure could raise concerns about revenue at risk. Having a forward-looking view of how concentration risk evolves will provide pivotal insight into whether your strategy is heading in the right direction.
Where it gets even more interesting, is when you have the ability to quantify your diversification benefits. Portfolio effects are more important than ever. Large funds are starting to turn the implicitly given diversification into measurable diversification benefits by managing their assets on a portfolio basis. Such a metric will give the necessary analysis of the above illustrated diversification strategy. For example, if the concentration risk is large, diversification effects will be minimal, and vice versa.
Portfolio Diversification Effects (P90 view)
In our case study, the impacts of a portfolio view compared to merely a country or asset view are crystal clear. But without quantifying the benefits, you would be unable to prove this to your shareholders. A major development that is already taking place is large funds aggregating their own portfolio with portfolios they manage on behalf of third parties to achieve a smoother cashflow line.
In addition, certain products such as Baseload PPAs are able to absorb more risk when viewed from a portfolio view and a combination of technologies and different assets. Valuation of Baseload PPAs is more challenging than Pay-as- Produced (PAP) ones. Both hedged and unhedged revenues carry a degree of uncertainty, because of the profile risk. When you are able to show that you can absorb – and therefore reduce – this risk through a portfolio view, your Baseload PPA will be significantly more bankable. And your shareholders will be more comfortable with your hedging decisions.
Written with contributions of our in-house masters David Willemsen, Head of Risk Advisory & Cédric Piaget, Senior Risk Expert at Pexapark.
If you want to discuss more on Pexapark’s Risk Reporting products reach out to Carlotta Carboni, Lead – Enterprise Software Sales at carlotta.carboni@pexapark.com.
