What is a power purchase agreement? (PPA)

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In this article, we are going to guide you through the power purchase agreement journey.

What is a PPA, how does it work, and most especially: how should you use it to increase the value of your renewable project.

(We’ve even included a downloadable checklist for your PPA negotiation) Let’s get started!

In this article, you’ll learn:

  • What does a power purchase agreement mean?
  • Why PPAs are used in renewable energy projects?
  • Why PPAs?
  • What are the benefits of a PPA?
  • Who needs a PPA?
  • What is the PPA process?
  • Who writes the initial contract?
  • What should you negotiate in your PPA?

You will also get:

  • A Power Purchase Agreement sample (CPPA EFET contract)
  • The PPA Prices in Europe (PPA Price Report)
  • A PPA Checklist explaining what you should negotiate in your PPA

What is a power purchase agreement?

Power Purchase Agreements (PPAs) are contractual agreements between energy buyers and energy sellers to purchase and sell energy generated by a renewable asset (existing or ready to build). PPAs are usually signed for long durations of up to 10-20 years.

Vocabulary Tip: The energy buyer is often called an offtaker, while the seller can also be a generator, an asset owner, or an investor.

Pro Tip: PPAs can be signed for existing assets that may have previously been under a feed-in tariff (with government subsidy) or to replace an expired contract.

Why PPAs are used in renewable energy projects?

To encourage renewables development, governments initially enabled investment with financial incentives such as subsidies (Feed-in-Tariffs, Feed-in-Premiums).

With improved technology, renewable assets have become cheaper to build over the past years, leading to a surge in their development.

Consequently, governments are increasingly moving away from subsidy schemes, as they cannot keep up with the financing or no longer see the need to provide incentives.

This market shift from subsidised projects to open markets has drastically affected renewables investors. They now need to find alternative securities to replace governments subsidies.

Vocabulary Tip: by open markets we mean the absence of government involvement, therefore, the absence of subsidies. 

Why PPAs?

For project financing:

Renewables often need third party funding sources, such as a bank. It’s unlikely that a third party will lend without a security. In the absence of a government subsidy, a PPA provides that assurance.

Vocabulary Tip: Third party lenders can be referred to as banks, lenders, credit providers, finance providers.

A typical European windfarm generating 100-megawatt (MW) can cost between EUR 1-2million per MW to build. Hence, the regular need for a credit provider, such as a bank, to finance the renewable project.

In order to do so, the finance providers require a certain level of confidence in a renewable project. This confidence is provided by the PPA, as a buyer commits to pay a fixed price per megawatt hour (MWh) for a long-term tenor (10-20 years) for the electricity that will be generated by the renewable asset.

One key risk to be assessed (from a lender’s perspective) is the counterparty’ risk: is this energy seller’s credit profile strong enough to ensure that it will still be operating in 10-20 years? Counterparties that lenders deem strong enough to finance the cash flows are called “bankable”.

For hedging:

Power Purchase Agreements provide a security that the project will bring return on their capital investment upon completion, by reducing the cash flow uncertainty.

PPAs enable the sell of a portion of a project’s future energy generation for a long-term (from 3 and up to 30 years) to an energy buyer. The PPA contract is often agreed in advance of a project being built.

Pro Tip: Tenors can vary significantly from a market to another. 

Investors are like risk managers; they aim to optimise their risk/return ratio. Entering into long-term PPA contracts is a way to manage the volatility risk: prices in power markets are extremely volatile as they can change very frequently (every 5 to 30 minutes).

In such contracts, the offtaker can in turn provide a fixed price for the long-term. This will guarantee a return on investment in the future, with minimum risk regarding expected revenues.

For long-term price predictability:

Electricity prices can fluctuate greatly and frequently. The main characteristic of a Power Purchase Agreement is the agreement to sell X amount of MWh from a renewables project to a buyer of energy at a fixed price.

While this allows a secure future stream of revenue on the seller’s side, the buyer, on the other hand, secures a certain amount of energy at a fixed cost.

Benefits of a PPA

For a renewable asset owner developer:

It allows renewables projects to increase their level of revenue certainty, which would not be possible in fluctuating energy markets without a government incentive.

A PPA;

  • Enables the financing of their renewable project by lenders
  • Reduces risks by efficiently allocating them among the contractual parties

For an energy buyer:

  • Assures fixed long-term costs
  • Enables a company to (indirectly) fund a renewables project and receive “green attributes”, such as Renewable Energy Certificates

For the lender:

  • Offers revenue certainty, as an amount of energy has been sold in advance at an agreed price
  • Allow for the claim of their contribution to the renewable industry

Who needs a PPA?

The Energy Buyers

Energy buyers can use PPAs to get their energy from renewable sources. This also enables them to reach their green energy goals.

  • Utilities are energy providers such as Axpo (Switzerland), Vattenfall (Sweden) and Holaluz (Spain). They have their own generating assets but also buy additional power to supply their customers. This also enables them to meet potential regulatory obligations set by governments (minimum green energy requirements or targets).
  • Corporates are companies with relatively large energy consumption needs across several locations such as: Google, Amazon, and Nike. They buy energy from renewable assets to achieve their ambition of reducing their carbon footprint.
  • Industrials are companies that require large amounts of energy for manufacturing, such as a mining company (Alcoa for aluminum production). They would enter into power purchase agreements in order to get certainty on their long-term energy costs.

The Energy Sellers

Energy sellers are the renewable asset owner or developer of renewable assets. They are commonly referred to as sellers, but also fall in different categories such as:

  • Investment companies that focus on infrastructure
  • Independent producers of electricity
  • Renewable energy asset managers
  • Utilities and energy companies that wish to build their own renewables assets
  • Infrastructure funds investing in renewables

The PPA process

Power purchase agreement process

1. How does it start?

The process of a Power Purchase Agreement starts with:

  • A renewable project ready to be built, that is, has a size, location, and a pre-agreed connection to the electricity grid. Or,
  • An existing project needs refinancing

2. Determine the Optimal Hedging Strategy

Form of a PPA

Power Purchase Agreement contracts come in many forms. You may have heard of physical and financial PPAs. There are other forms but for this introduction, we’ll focus on those two.

What is a Physical PPA?

Physical PPAs imply that the energy will directly be bought at the meter point (reception point of production), typically by a utility to supply the energy to its many customers through the existing transmission lines.

Physical PPA

What is a Financial PPA?

A financial PPA allows a company to buy renewable energy virtually. This can be done without the need to own the title of the physical energy. This enables companies focused on their “green impact”, such as corporates, to receive renewable attributes without owning the asset.

These “green” additionalities allow a credit link between the purchaser and the renewable asset owner. A financial PPA will not impact the source of energy consumed by the purchasing company.

Vocabulary Tip: Renewable attributes are energy credits, renewable energy certificates, etc.

Financial PPA

 

PPAs’ underlying structure

In addition to various contractual forms, PPAs also come with different underlying structures and with different forms of hedging that will distribute the diverse energy risks between the buyer and seller. Some of the most common forms includes pay-as-produced, annual or monthly baseload.

3. Sourcing

In order to receive buying offers, the renewable project owner usually goes through a request for proposal or quotation (RFP/RFQ), so interested energy buyers can make an offer of purchase.

Pro Tip: For large established buyers such as Google, the process can be different. In this case, Google tends to launch private tenders, or auctions, where they invite pre-selected parties to bid against each other in several rounds.

 

4. Compare PPA offers

Initial offers often do not feature a lot of details. They contain only the core commercial conditions and are often called Term Sheets.

They include, at a minimum, a price, a tenor and a PPA structure. The offers received can vary a lot from one offtaker to another (different underlying structures, the inclusion of some costs which are not included in others, different price area basis, etc.). It can therefore be complex to compare one offer against another.

At Pexapark, we compare these offers by running thousands of price scenarios based on our proprietary model. This enables us to advise our clients on the optimum structure for their PPA, to maximize their expected revenue and reduce their risk.

5. Negotiation

While an approximate price can be agreed upon quite in advance, the details of the contract negotiation can take between 6 to 12 months. Many key important points that need to be agreed upon

-> Later in this article, you’ll find our PPA checklist, containing the 10 commercial points you shouldn’t miss to negotiate your PPA.

Comparing and negotiating are critical parts of the PPA process. Upon signing, the project is now more likely to receive lending, and construction can either start for a specific Commercial Operation Date (COD) or an existing project can be refinanced.

Vocabulary Tip: Commercial Operation Date is a common phrase used to describe the date at which the renewable asset has committed to start producing energy.

6. Sign the PPA contract

Agree and sign your PPA contract.

7. The PPA is signed, then what?

PPAs enable the investment in a renewable project by guaranteeing the future purchase and sale of energy at an agreed price today. However, the energy sales of the asset still need to be managed throughout its life. While a PPA contract may have been signed for 10 years, the asset may continue on for 30 years.

Monitoring the evolution of the market will help you answer these critical questions:

When is the deadline to re-negotiate a new contract?

Should I re-negotiate a new contract?

How much risk am I now exposed to?

What is the mark-to-market value of my asset?

If I add an asset to my portfolio, how will it impact my overall risk/revenue exposure?

PPAs are complex financial contracts within a buyer’s financial portfolio and should be managed as such. Proper value tracking and active management is required as well as specific strategies to protect a PPA’s value amid volatile energy markets.

This requires a strategy to monitor the asset’s value periodically and perform a mark-to-market valuation (the market value of the asset at a point in time) as prices evolve over time.

It is important to keep track of the exposure to market risks. Such systematic assessment will also identify key contract risks and inform targeted risk mitigation strategies to help lock in a reasonable value at the time of contract signing.

Pro Tip: PPAs are often contracted for less than 100% of the asset’s volume. This means that a portion of the energy sales will always be exposed to market risks, even under a PPA contract. Typically, banks require a hedge of 70% of the total production of the asset.

Who writes the initial PPA contract?

The buyer usually creates basic offers based on the RFP/RFQ from the energy seller. Should there be interest on the seller side, the buyer will then provide a more detailed contract.

Check out EFET standardized CPPA contract

PPA negotiation

You are in the midst of a PPA negotiation….but have you thought of everything?

We got your back and created a PPA checklist to ensure you are covered!

Here are the 10 commercial key points you shouldn’t miss if you want to successfully close your next PPA.

(You’ll find a downloadable checklist at the end of the article.)

  1. Commercial structure

The type of PPA structure you choose (pay-as-produced, annual baseload, etc.) will impact how the energy risks are distributed among the parties. For example, for the volume risk, in a pay-as-produced structure (a fixed price is paid for any volume produced), the buyer will carry a portion of the volume risk, but the seller is responsible for over – or underperformance.

Whereas in a monthly baseload structure, (a contract that buys a constant volume of energy every hour of each month), the volume risk will be carried by the seller as the volumes are to be guaranteed on a monthly basis.

  1. Understand Energy Risks

Knowing how much each energy risks you are carrying is essential to be able to negotiating a PPA. This will be key to successfully negotiate your contract.

We recommend you go over the following 5 key energy risks:

Price Risk:

This risk is the probability that there is an adverse movement in the market price. It is unavoidable but can be mitigated by taking a future position of approximately the same size but in an opposite price direction in an exchange.

Liquidity Risk:

A market is called liquid if buyers and sellers can conclude large volume transactions quickly, without impacting the market price. Depending on the structure of the PPA, its cost or risk can be reduced.

This could be done, for example, by getting a validity period (which comes at a cost) or agreeing on a price formula indexed on closing prices. The contractual parties (buyer and seller) could agree to fix the PPA price closure referenced on publicly available prices such as forward prices observed on an exchange.

Volume Risk:

The annual energy production of a renewable asset is an estimate, whose likelihood is typically calculated and assessed on the basis of long-term meteorological data.

If a renewable asset is hedging a fixed volume at a fixed price, there is a risk that certain amounts of volume are not produced and need to be procured. If this is the case the producer may have to purchase the missing volume at market prices that may be worse than the original fixed price. Optimizing the volume risk is crucial.

You can make use of insurance guarantees or use certain PPA structures to reduce this risk.

Pro Tip: It is important to note, however, that there is always a portion of the volume risk carried by the project owner. What if the plant is not producing any energy, even under a pay-as-produced structure (a fixed price is paid for the energy produced) there is a form of volume risk due to potential non-production.

Profile Risk:

Profile risk arises from the fluctuating nature of renewable energy (for example, there are no solar energy produced at night). In markets with high renewable energy penetration, times of high production can mean a significant decrease in power price, that is, revenue.

This will depend of course on the location of the plant and type (solar or wind). You can mitigate this risk by choosing certain PPA structures.

Balancing Risk:

The difference between what was scheduled, usually a day ahead, and actual production (the imbalance cost). This risk can be reduced by fixing the imbalance cost through an agreement or using intraday trading (if available).

  1. Duration

Below are some of the most important questions to consider regarding the duration of your contract:

  • Do you know for how long the fixed price is set for?
  • Do you have to renegotiate the price before the end of your PPA contract?
  • How is the start date of your PPA contract defined?
  • Will the contract start upon COD (Commercial Operation Day)?
  • If production does not happen, is there a grace period? If yes, how long is it and will it come at a cost?
  1. Price Fixing

Sometimes closing a deal can take months… (from negotiating a PPA contract to closing it). Within these months, market prices can change, i.e. liquidity in the market can change and this could impact the price rather significantly.

In order to mitigate significant price swings in your PPA negotiation, a reference price can be defined. Ideally, you would want daily updated PPA prices… Oh, but wait, we do provide that! Check out PexaQuote, our PPA price software!

  1. Credit risk (on both seller and buyer sides)

The credit risk refers to the risk that the buyer will not be able to meet its contractual payment obligations agreed into the PPA contract. Know who your direct counterparty is and follow their company’s credit development.

Protections can be put in place, such as advanced payments, margining requirements, increased frequency of payments and a Material Adverse Clause (MAC). The same applies to the seller, e.g. What if the project runs out of money before COD? A guarantee needs to be in place.

  1. Settlement

Is this a physical or financial PPA? Financial PPAs have been hyped in the US but have proven to be unpopular in Europe.

There are two key difference in these PPAs contracts:

Accounting:

A financial PPA will be treated as a financial derivative and therefore will fall under specific accounting requirements set by the IFRS (International Financial Reporting Standards). This often means relatively complex accounting, requiring mark-to-market valuing.

Physical PPAs on the other hand, only account for the realized sale, which means a relatively simpler accounting structure.

Credit:

For a financial PPA, the contracted volume will be traded on the market through a TSO and will comply with the credit requirement of the TSO.

For a Physical PPA, the credit requirement will come from the buyer and often at higher credit requirements.

Negative pricing is an increasing issue with renewables. It is critical to understand the market in which one is operating and know how these negative prices are treated. This is an important (there may be clauses in the contract that forces the asset to stop producing during prolonged negative prices) and often overlooked item in a PPA contract.

  1. Underlying contract

Do you have an underlying master agreement contract in place, based on the EFET (European Federation of Energy Traders) or an ISDA (International Swaps and Derivatives Association)? In this case a term sheet usually suffices as the underlying contract has already been negotiated between the respective parties.

If this is not the case, then a long-form contract can be used where all the terms of the agreement are defined.

  1. Changes in law and regulations

What happens if there is a change in law that materially affects the obligations of one or both parties in the agreement? What if there is a change in the law affecting taxes? This can affect the balance of revenues or risk between the parties.

It is important to note how these changes will be treated in the PPA.

  1. Performance guarantees

Guaranteed availability is a percentage of the volume that is guaranteed in the contract. Know how under-performance will be contractually treated.

A performance guarantee refers to the case where the production at COD does not meet the contractually agreed-upon expected production. Consider how this settlement will be addressed between both parties. In which case will the seller have to compensate the offtaker?

  1. Termination

Know what reasons will trigger an early termination of your PPA contract and at what cost. Triggering examples are a default, COD not occurring before a specific time, etc.

There is a reporting obligation under REMIT (Regulation on wholesale energy market integrity and transparency), where wholesale energy market participants are required to report to the European Agency for the Cooperation of Energy Regulators (ACER) details of transactions and orders in relation to wholesale energy products (price, quantity, dates, etc.). It is important to note who will be taking care of the obligatory reporting and at what cost.

Pro tip: EMIR (European Market Infrastructure Regulation) is a body that regulates over-the-counter derivatives for financial PPAs.

Conclusion

A PPA is a contractual agreement to purchase an amount of energy at an agreed price, for a certain time in advance of producing the energy.

PPAs have arisen in renewable energy business due to the disappearance of government subsidies. Subsidies once provided a financial security for lending institutions such as banks, to invest in a renewables project.

Without subsidies, lenders require a new way to secure their investment. This can be provided in the form of PPAs, which are long term contracts, proving that the renewable asset has already found a long-term buyer at a fixed price.

PPA contracts can be described as enabling investment in renewables in unsubsidised markets by providing revenue certainty to investors and lenders.

While these contracts are enablers, they are also complex in their structure and in their pricing. This begs the need for a thorough understanding of energy risks, valuation, and negotiation issues.

Important clauses can be forgotten or inadequately negotiated, Impacting the overall revenue of the PPA project. We take the weight off renewable investors shoulders by guiding them throughout their renewable project, making sure they maximize their revenues. Get in touch with us today and see how we could help you make the best of your PPA.

 

Giveaways

What are the prices in Europe? In general, there is a lack of transparency in the market on PPA prices. There are not readily available. The process to get there is cumbersome. You would need to contact potential buyers, outline your project, sign NDAs, and maybe get a price range.

We are providing PPA Prices across Europe for free. How do we do this? We have over 15 years of experience in origination. Thanks to this experience, we understand energy buyers and calculate fair values of PPAs – check it out it’s free.

Vocabulary Tip: NDAs are Non-Disclosure Agreements, necessary legal document to ensure that the information shared between the parties stays confidential.

Origination: The process of originating deals into the trading desk of the company. Providing services and products to solve clients’ energy needs or problems.

The European Federation of Energy Traders, published a standard Corporate Power Purchase Agreement (CPPA) in cooperation with RE-Source Platform. This standard contract has been circulated and reviewed among industry stakeholders in response to the need for standardization.

Pro Tip: The European Federation of Energy Traders is an association advocating policies and regulations in electricity and gas trading in Europe. It was established in 1999 to support the liberalisation of electricity and gas markets in Europe. 

The RE-Source Platform is an alliance of European stakeholders representing clean energy buyers and suppliers for corporate renewable energy sourcing.

EFET standard contract – link

PPA Checklist – 10 commercial keys points you shouldn’t miss for your negotiation

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Images from the PPA checklist

PPA Checklist

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