Search
Record renewable generation has left some energy market participants rushing to come to grips with how to price Power Purchase Agreements (PPAs) and manage risk in this rapidly growing asset class.
According to a recent report by Reuters, a record 60% of Europe’s electricity was powered by clean energy sources during Jan-Feb 2024, driven by strong year-on-year growth in hydro, solar and wind generation and a rebound in nuclear power production.
The recent shift to this emerging asset class has left some participants rushing to understand where PPAs fit into their overall portfolio, and how to effectively trade and manage the risk profiles of these assets.
To assist, we’ve put together this introductory article, designed to cover the basics of buying, selling, and managing risk of PPAs in your portfolio.
Typical PPA structures
PPAs offer purchasing parties access to renewable generation sources, bypassing significant upfront capital costs, and the planning, application and development process.
PPAs are often sold at a slight discount to the standard forward price as they offer generators some price certainty in the form of a fixed-price revenue stream.
There are several key types of PPA structures you need to be aware of, including physical and financial:
- Pay-as-Produced – More complex to manage and hedge against because as the name implies, you’re taking the power output as it’s produced. This introduces volume uncertainty and makes it hard to match a specific demand profile. In return, they are typically priced cheaper to alternative similar structures.
- Fixed Volume Delivery – Transfer the volume uncertainty risk onto to the generator as any shortfall generation periods below the agreed fixed volume will need to be fulfilled by the generator from sources such as the short-term market. These PPA structures are therefore priced higher to cover such risks to the generator.
- Pay-as-Consumed – The lowest-risk structure PPA for a purchaser where 100% of the volume risk is passed onto the generator, because these PPAs match your consumption demand. As a result, they have the most expensive pricing structure of the three described here.
Understand your role in the process
Understanding your role helps to define your position/appetite on the characteristics of different PPAs and so is critical to choosing a PPA structure based on its suitability to your requirements.
For example, investors, utilities, and aggregators may be looking more closely at things like volume transfer risk, and whether they’re appropriate for their business model.
The factors to consider when purchasing PPAs include:
- Whether you’re taking on price risk from the cost or revenue elements of the PPA
- Whether you’re exposed to volume risks
- What the costs of the risk transfer are, and whether they’re fair
It also helps to consider your current capabilities in this space. Do you have the tools and expertise to capture and model the key characteristics of PPAs to effectively analyse the different risk dimensions? If you’re new to PPAs, or your risk function is still maturing, it may make sense to start with simpler PPAs that don’t demand the same level of sophistication.
Conduct pre-trade deal analysis
The first step in effective analysis is to capture their key characteristics correctly.
Next, you need to accurately understand the dynamics of both renewable energy sources (e.g. wind speeds or solar irradiance) and those of the relevant power price markets. To do so, you need to capture intraday price shape, along with monthly/seasonal characteristics, as well as price and energy source volatilities, jumps, mean reversion rates, and relevant correlations. It’s important to capture half-hourly or hourly price data as it allows for necessary pairing with fundamental generation sources such as intraday wind speeds and solar irradiance.
The choice of calibration techniques and categorisations is important as it ultimately affects the accuracy and reliability of your price shapes and model parameters.
The above chart shows a seasonally-influenced curve with pronounced morning and evening peaks, especially in September. You can also visualise this data in other ways such as peak/off-peak.
The next step in the process is to combine the equivalent intraday shapes for the renewable variable with energy conversion rates to calculate your megawatt production outputs – for example by using an S-curve conversion for wind generation derived from wind speed.
By running joint simulations of power and the renewable source, simulated cashflows resulting from the operation of the asset (or payoff of the PPA) can be calculated. The resulting simulations can be further combined to determine the distribution of the payoffs as well as the (present) value of the contract or asset.
The above chart shows the output of 1,000 simulations of hourly payoffs for the target PPA and its risk distribution, aggregated on a monthly basis, allowing you to identify price seasonality and implicit forward curve structure trends.
Managing risk post-trade – Choosing the right hedging strategy
Hedging tools not only reduce risk but can also add value to your PPA portfolio.
Once you have derived the potential cashflow distributions from the analysis described earlier, you also have insights into the tails of the distribution that define your risk exposures and can either source products to hedge against that exposure for that PPA, reducing the distribution risk profile, or choose alternative PPAs that offer narrower risk spreads.
Basic hedging tools available for PPAs include:
- Baseload flat hedge
Pros: Simple, most liquid. Suit longer-dated periods
Cons: Exposed to seasonal, intraday and volume price risks
- Seasonal Price Shape Hedge
Pros: Improved hedge to factor seasonal price shape
Cons: Only available/liquid at front end of market curves. Still exposed to intraday shape risk
- Off/Peak Hedge (price and/or volume)
Pros: A hedge which factors in intraday price/volume shape risk
Cons: Potential reduced liquidity. Still exposed to seasonal shape risk
- Seasonal Off/Peak Hedge (price and/or volume)
Pros: Combines all above benefits
Cons: Liquidity limitations may still lead to price and volume imbalance risks
Depending on your needs and level of sophistication, you can also choose to investigate more elaborate risk protections such as buying put options, but there is often a liquidity trade-off which limits availability for the necessary hedges.
Analyse the effectiveness of hedges
Assess the effectiveness of your hedging strategies by running an analysis of your hedges alongside your PPA analysis using the same input characteristics. An effective hedge should see your distribution risk profile contract.
The above chart shows how hedges can narrow the distribution risk spread.
Analysis like this allows you to refine your strategies to identify the optimal strategy for your needs.
To find out more about pricing and identifying risk in PPAs using Lacima Analytics > Renewables, email info@lacimagroup.com
