What is a PPA?
The wholesale electricity market
Electricity produced in each country is often sold through regulated markets. In these “wholesale” markets, large volumes of electricity are traded, involving different agents such as energy producers, utilities, brokers and some large consumers.
In the wholesale electricity market, energy producers make daily offers for the sale of their electricity. These offers intersect with the demand made by buyers. The price resulting from this supply and demand curves intersection is called a “spot” price or market price, which is a fluctuating and sometimes volatile price.
A PPA is a contract to purchase electricity between an energy producer and an energy buyer at an agreed price and for a given period of time (usually around 10 years). It is called “Power Purchase Agreement”.
By fixing a long-term contract price, the PPAs minimize the parties’ exposure to the volatility of the electricity market: the energy producer knows in advance what it will charge for the energy produced and the buyer will be certain of what it will pay for that electricity for the entire duration of the PPA.
Parties under PPA contracts
While sellers are generally owners of the power plants (energy producers), buyers under PPAs usually are:
- Large consumers: there are companies with large electricity consumption or focused on sustainable business practices that want to reduce their carbon footprint looking for a financial return to these green initiatives. These types of companies acquire electricity directly from renewable generation projects, optimising long-term energy costs and achieving their environmental sustainability goals.
- Utilities/traders: who purchase energy under PPA contracts (in addition to buying it in the open market) in order to meet the demand of their customers.
The buying party under a PPA contract is often referred to as an “Offtaker”.
Apart from self-consumption projects, where the generation plant and electricity supply point are at the same site and the connection is made physically without going through the power grid, there are PPAs where the generation plant can be hundreds of kilometres away from the consumer location. In these cases, the electricity generated by the energy producer is physically delivered to a specific delivery point of the network and on the other hand, the purchaser acquires said energy (or the rights thereof) through its utility or its usual representative agent in the electricity market.
Under this PPA scheme, it is necessary for the buyer to retain a utility company or a market agent who acquires the electricity generated by the project and then transmits it to the consumer at the agreed price.
The price to be paid for the electricity by the Offtaker will be the price agreed under the PPA, plus the connection and distribution costs and the utility’s (or agent’s) fees.
Also called synthetic, virtual or Contract for Difference (CfD) PPA. This type of contract works as a financial hedge contract without physical delivery of electricity.
Under this scheme, the energy producer sells its energy on the open market at the corresponding spot price. On the other hand, the buyer continues to purchase its electricity from its utility in the usual manner.
Under a Financial PPA, the parties agree on an electricity volume (e.g. in annual MWh), the applicable price for that electricity volume, the term of the contract (for example, 10 years) and an index or wholesale market reference price, in such a way that
- If the market reference price is higher than the PPA price, it is understood that the energy producer is receiving incremental revenues from the market (as compared against the PPA) and must pay the difference to the buyer.
- On the contrary, if the reference price is lower than the PPA price, it is understood that the buyer is paying less (as compared against the PPA) and must pay the difference to the energy producer.
In addition, the energy producer usually provides the buyer with green certificates which prove that its consumption linked to the PPA comes from renewable generation sources.
Given their flexibility, these types of contracts are the most commonly used and preferred by some multinationals.
PPAs underlying structure
The PPAs determine the distribution of risks between its parties (i.e. between the generation project and the Offtaker). Some of the main risks to be taken into account in a PPA are:
- Risk Volume: the energy generation volume estimated for a renewable project and agreed under a PPA is based on long-term technical and meteorological information. The main alternatives to determine the allocation of this risk between the parties are the following:
- Pay as produced, where the buyer undertakes to purchase all production or a percentage of actual production from the generation plant (and thus assumes the risk of production) and
- Fixed volume (baseload), in which the parties agree on a fixed electricity volume for each period (annual, semi-annual, etc.) so that the energy producer assumes the risk to comply with the agreed production and the delivery of the corresponding guarantees of origin.
- Profile Risk: The profile risk is derived from the variable nature of the renewable source of a generation project (for example, there is no solar radiation during the 24 hours of the day). This risk is determined by both the technology of the generation project (e.g., solar, wind, etc.) and the renewable resource (solar radiation or wind level) which is largely derived from the location of the projects. This risk is usually covered and distributed among the parties with the PPAs’ own structures.
- Counterparty Risk: Counterparty risk refers to the credit risk of your counterparty under the PPA and the potential non-compliance of their contractual obligations (e.g. payment obligations under a financial PPA). It is therefore important to validate a minimum creditworthiness of the counterparties that mitigate the possible default risks. This risk is also covered by credit support structures and guarantees established in the PPAs.
- Pricing Fixing Risk: Currently, the negotiation and closure of a PPA is often a complex, costly, and lengthy process (for example, between 9 and up to 18 months in some cases). During this period, it is possible to observe a variation in the electricity market prices that brings with it more complexity for the possible closing of these contracts. It is therefore important to facilitate and reduce the timing for the PPAs negotiation and closing.
PPAs provide feasibility to new renewable projects
Entities financing the construction of new renewable projects are reluctant to lend money to projects with volatile revenues obtained from the wholesale market.
Such financial institutions need to ensure that the project will have stable revenues (e.g. through PPA fixed price structures) from solvent counterparties, which allow a project to repay the loans granted for the construction of the plant.
PPAs provide this cashflow stability and are therefore necessary to provide feasibility to many renewable generation projects.
The pre-screening implemented by Sanza validates the suitability of both, buyers and energy producers, to operate on our platform and offers credit enhancement instruments that improve credit quality of our PPAs. In this manner we fulfil our objectives of democratising access to more competitive renewable energy and contribute to an energy transition to sustainability.
Accounting implications of a PPA
In general terms, the physical PPAs are accounted for based on the agreed energy price considering the electricity volume delivered under the PPA.
On the other hand, the financial PPAs are accounted for at their mark to market value, taking into account market forecasts and expected future cash flows under the PPA.
Sanza offers tools which help you to calculate the mark to market value of your PPAs at every moment.
PPAs are contracts that require active management by both parties (e.g. to track its value, to define the energy risk management strategies, etc.).
Such active management will allow the parties to protect the value of the PPA against possible price volatility scenarios in the electricity spot market.
An active PPA management includes conducting periodic market valuations of the PPA contract according to the electricity spot market prices variation (mark-to-market).